Credit Crunch Caused Investment Slump? An Empirical Analysis Using Finnish Data

The objective of this paper is to empirically analyze and quantify the effect of changes in the supply of bank credit on private investment. Particular interest is placed on the role of the credit crunch in explaining the collapse in private investment in the early 1990s. Using a vector autoregressive econometric model, it is shown that the credit supply plays a statistically significant and economically important role in determining investment. The effect of credit on investment comes through with a lag of about a year and persists for several years. Money supply is a powerful investment predictor in a bivariate relation, but loses its significance completely once credit is included in the model. Hence, in the light of history, it appears that the money supply has had little effect on investment except as relayed through credit and, to a lesser extent, through the interest rate. On the other hand, since strong contemporaneous comovements were found between money and credit, the contemporaneous effect of money on credit may be considerable. In general, the results were found to be consistent with the credit view of the monetary transmission mechanism: monetary policy affects both sides of bank's balance sheets — money supply and credit supply — and credit seems to be the more important predictor for investment. It is estimated that positive shocks to the credit supply during 1986–1988 raised the peak for private investment in 1990 by about FIM 25 billion annually. On the other hand, the subsequent negative shocks deepened the collapse of investment by approximately FIM 20 billion annually.