Macroeconomics

Credit and demand

New credit can finance consumption, investment, or asset purchases. The macroeconomic effect depends on the destination:

• Credit for productive investment can raise future output and productivity.
• Credit for consumption can support demand in the short run but may not build capacity.
• Credit for existing assets, especially housing, can raise prices and collateral values without adding much to the capital stock.

This is why "money growth" alone is not a sufficient guide to inflation. The same increase in credit can show up in output, prices, or asset valuations, depending on the state of the economy and the behaviour of borrowers and lenders.

The sectoral balances identity

A useful accounting framework is the sectoral balances identity. Let S be private saving, I private investment, T taxes, G government spending, X exports, and M imports. In a simple open economy:

(S − I) + (T − G) + (M − X) = 0

The private sector's financial balance, the government's fiscal balance, and the foreign sector's balance must sum to zero. If the private sector wants to save more than it invests, and the foreign sector is not borrowing, the government must run a deficit — or the identity will be satisfied through a recession that changes the underlying flows.

This is an identity, not a policy prescription. It does not say that deficits are always good or always bad. It says that the balances are connected, and that claims about one sector must be consistent with the others.

Debt cycles

Credit creation can support a long expansion, but it also builds debt. When debt is high relative to income, borrowers are more sensitive to falls in income and asset prices. A shock can force deleveraging: households and firms cut spending to repay debt, which reduces income for others and can make the debt burden worse.

This is the core of a balance-sheet recession. Richard Koo's work on Japan describes a period in which firms and households shifted from profit maximisation to debt minimisation. Even with near-zero interest rates, they did not want to borrow. The private sector was repairing its balance sheet, and the government had to absorb the shortfall in demand.^[1]

Mian and Sufi's work on the U.S. housing boom and bust makes a related point: the distribution of debt matters. When highly leveraged households cut spending, the effect can be large and persistent, especially when their homes are underwater.^[2]

Financial cycles and the business cycle

Financial cycles can be longer than business cycles. Credit and asset prices can rise for years, creating the conditions for a sharper downturn later. Borio argues that macroeconomics should pay more attention to the financial cycle, rather than treating it as a temporary deviation from equilibrium.^[3]

Long-run research finds that credit booms are associated with financial crises and that the composition of credit matters. Mortgage credit expansions, in particular, have been linked to deeper recessions.^[4]

Inflation and deflation

Inflation is a sustained increase in the general price level. Deflation is a sustained decrease. Both can be driven by demand, supply, expectations, and money and credit.

• Demand-pull inflation occurs when spending outruns the economy's capacity.
• Cost-push inflation occurs when input costs rise, such as energy or wages.
• Monetary inflation is associated with rapid money and credit growth, but the relationship is not fixed.
• Deflation can result from a collapse in demand, a credit contraction, or a productivity-driven fall in costs.

The policy response depends on the cause. A supply shock may require a different response from a demand collapse. A financial crisis may require liquidity and fiscal support, not just a lower policy rate.

Fiscal and monetary interaction

Monetary policy affects the cost of government borrowing, and fiscal policy affects aggregate demand and inflation. In a deep recession, monetary policy may be constrained by the effective lower bound, making fiscal policy more important. In an inflation, fiscal support can add to demand and complicate the central bank's task.

The interaction is not a simple hierarchy. The central bank has tools to influence liquidity and interest rates. The fiscal authority has tools to tax, spend, and transfer. The right mix depends on the shock, the credibility of the framework, and the constraints on each institution.^[5]

Where to go next

• Money supply — what the aggregates measure.
• Monetary policy — transmission and limits.
• Financial risks — leverage and procyclicality.
• Deflation risk — debt deflation and liquidity traps.