Nonlinear Credit Dynamics, Regime Switches in the Output Gap and Supervisory Shocks

Abstract

Over the last two decades the intensity of credit standards’ tightening during economic contractions has exceeded their easing during expansions among euro area banks. This mechanism is fed by the boom-bust cycle of credit that, as much research has shown, is linked to financial instability with large effects on the real economy. We build a small scale nonlinear quadratic (NLQ) model to study how credit feedback can affect the overall adjustment path of the economy towards some steady state, when the central bank solves a finite-horizon decision problem where the policy rate is allowed to also be zero or negative. Then, we estimate local projections for a super- visory shock hitting banks’ credit standards and propose a new external instrument to identify its dynamic causal impact on the real and financial sector. We find that the regime dependence reveals important information to policy makers to implement macroprudential measures.