Financial Instability - a Result of Excess Liquidity or Credit Cycles?

Christian Heebøll-Christensen
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Christian Heebøll-Christensen: Department of Economics, University of Copenhagen

No 11-21, Discussion Papers from University of Copenhagen. Department of Economics

Abstract: This paper compares the financial destabilizing effects of excess liquidity versus credit growth, in relation to house price bubbles and real economic booms. The analysis uses a cointegrated VAR model based on US data from 1987 to 2010, with a particulary focus on the period preceding the global financial crisis. Consistent with monetarist theory, the results suggest a stable money supply-demand relation in the period in question. However, the implied excess liquidity only resulted in financial destabilizing effect after year 2000. Meanwhile, the results also point to persistent cycles of real house prices and leverage, which appear to have been driven by real credit shocks, in accordance with post-Keynesian theories on financial instability. Importantly, however, these mechanisms of credit growth and excess liquidity are found to be closely related. In regards to the global financial crisis, a prolonged credit cycle starting in the mid-1990s - and possibly initiated subprime mortgage innovations - appears to have created a long-run housing bubble. Further fuelled by expansionary monetary policy and excess liquidity, the bubble accelerated in period following the dot-com crash, until it finally burst in 2007.

Keywords: financial instability; housing bubbles; credit view; money view; cointegrated VAR model; impulse response analysis (search for similar items in EconPapers)
JEL-codes: C32 E44 E51 G21 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2011-08
New Economics Papers: this item is included in nep-ban, nep-cba and nep-fdg
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Persistent link: https://EconPapers.repec.org/RePEc:kud:kuiedp:1121

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