How do credit supply shocks affect the real economy? Evidence from the United States in the 1980s

Read the full PDF in your browser (opens in a new tab)

We explore the 1982 to 1992 business cycle in the United States, exploiting variation across states in the degree of banking deregulation to generate differential local credit supply shocks. We show that expansion in credit supply operates primarily by boosting local demand, especially by households, as opposed to improving labor productivity of firms. States with a more deregulated banking sector see a large relative increase in household debt from 1983 to 1989, which is accompanied by an increase in the price of non-tradable relative to tradable goods, an increase in wages in all sectors, an increase in non- tradable employment, and no change in tradable employment. Credit supply shocks lead to an amplified business cycle, with GDP, employment, residential investment, and house prices increasing by more in early deregulation states during the expansion, and then subsequently falling more during the recession of 1990 and 1991. The worse recession outcomes in early deregulation states appear to be related to downward nominal wage rigidity, household debt overhang, and banking sector losses.