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The Role of Credit in the 2007–09 Great Recession

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  • Mohammed Dore

    ()

  • Rajiv Singh

Abstract

This paper examines the financial crisis of 2007/9 and the downturn in the U.S. We argue that effective demand over the 2001–2006 expansion was maintained by credit. The role of credit in a Vector Error Correction Model and Granger-causality between aggregate spending, credit, disposable income, and profits are examined. We show that credit itself is determined by factors outside the circular flow of income. The results raise new hypotheses about the crucial relationships in macroeconomics that sustain aggregate spending. We then compute the generalized impulse responses in the VECM to demonstrate the severity of the downturn and show that legislative changes that dismantled the restrictions placed on the financial sector and the consequent structural changes after 1980 enabled the growth of new debt instruments and credit. The overexpansion of credit when profits and house prices were declining in 2005/06 and informational asymmetries on the quality of credit and its sudden withdrawal in 2007 paralyzed the economy and led to the Great Recession. Copyright International Atlantic Economic Society 2012

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Bibliographic Info

Article provided by International Atlantic Economic Society in its journal Atlantic Economic Journal.

Volume (Year): 40 (2012)
Issue (Month): 3 (September)
Pages: 295-313

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Handle: RePEc:kap:atlecj:v:40:y:2012:i:3:p:295-313

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Keywords: Financial crisis; Recession; Deregulation; Credit; VAR; Vector error correction; Granger-causality; Great depression; E32; E50; G01;

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  1. Gary Gorton, 2008. "The Subprime Panic," Yale School of Management Working Papers amz2504, Yale School of Management.
  2. Davidson, James E H, et al, 1978. "Econometric Modelling of the Aggregate Time-Series Relationship between Consumers' Expenditure and Income in the United Kingdom," Economic Journal, Royal Economic Society, vol. 88(352), pages 661-92, December.
  3. John B. Taylor, 2009. "The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong," NBER Working Papers 14631, National Bureau of Economic Research, Inc.
  4. Gorton, Gary B., 2008. "The panic of 2007," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 131-262.
  5. Carmen M. Reinhart & Kenneth S. Rogoff, 2008. "This Time is Different: A Panoramic View of Eight Centuries of Financial Crises," CEMA Working Papers 595, China Economics and Management Academy, Central University of Finance and Economics.
  6. Stephen G. Cecchetti, 2008. "Crisis and Responses: the Federal Reserve and the Financial Crisis of 2007-2008," NBER Working Papers 14134, National Bureau of Economic Research, Inc.
  7. Michael D. Bordo, 2008. "An Historical Perspective on the Crisis of 2007-2008," NBER Working Papers 14569, National Bureau of Economic Research, Inc.
  8. repec:nsr:niesrd:313 is not listed on IDEAS
  9. Gary B. Gorton, 2008. "The Panic of 2007," NBER Working Papers 14358, National Bureau of Economic Research, Inc.
  10. M. Woodford., 2010. "Convergence in Macroeconomics: Elements of the New Synthesis," VOPROSY ECONOMIKI, N.P. Redaktsiya zhurnala "Voprosy Economiki", vol. 10.
  11. Edward E. Leamer, 2007. "Housing IS the Business Cycle," NBER Working Papers 13428, National Bureau of Economic Research, Inc.
  12. Pesaran, H. Hashem & Shin, Yongcheol, 1998. "Generalized impulse response analysis in linear multivariate models," Economics Letters, Elsevier, vol. 58(1), pages 17-29, January.
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Cited by:
  1. Mohammed Dore & Roelof Makken & Erik Eastman, 2013. "The Monetary Transmission Mechanism, Non-residential Fixed Investment and Housing," Atlantic Economic Journal, International Atlantic Economic Society, vol. 41(3), pages 215-224, September.

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