Thursday, April 16, 2009

Financial Linkages and the Real Economy

The most recent Bank of Canada's senior loan officer survey showed that despite the historic level of monetary stimulus, bank lending in Canada is still remarkably tight. The implications for New Keynesian type forecasting models that rely on Taylor-type reaction functions is that the current disconnect between monetary policy and private sector borrowing conditions will be missed However, recent research by economists at the IMF offers a simple way to incorporate financial linkages loan officer survey data.

I am planning to incorporate these financial linkages into my larger model, but for now I thought it would be interesting to run a quick and dirty VAR. The figure below shows the impulse response of Canadian real GDP growth to a one standard deviation lending tightness shock.

This simple VAR analysis reveals that a one standard deviation shock to the BoC senior loan officer index (about 15 points) translates to a -0.35% decline in real GDP growth after four quarters. This would indicate that current lending conditions (an index reading of about 60) will have persistent negative effect on the economy and further highlights the importance of addressing the liquidity needs of the Canadian banking system.

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