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The Role of Credit in the 2007–09 Great Recession

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  • Mohammed Dore

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  • Rajiv Singh
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    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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    File URL: http://hdl.handle.net/10.1007/s11293-012-9326-2
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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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    Related research

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

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    References

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    1. 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.
    2. Gary B. Gorton, 2008. "The Subprime Panic," NBER Working Papers 14398, National Bureau of Economic Research, Inc.
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    4. Gary Gorton, 2008. "The Panic of 2007," Yale School of Management Working Papers amz2372, Yale School of Management.
    5. Pesaran, M. H. & Shin, Y., 1997. "Generalised Impulse Response Analysis in Linear Multivariate Models," Cambridge Working Papers in Economics 9710, Faculty of Economics, University of Cambridge.
    6. Gorton, Gary B., 2008. "The panic of 2007," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 131-262.
    7. Edward E. Leamer, 2007. "Housing IS the Business Cycle," NBER Working Papers 13428, National Bureau of Economic Research, Inc.
    8. 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.
    9. 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.
    10. 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.
    11. Michael D. Bordo, 2008. "An Historical Perspective on the Crisis of 2007-2008," NBER Working Papers 14569, National Bureau of Economic Research, Inc.
    12. Ray Barrell & Ian Hurst & Simon Kirby, 2008. "Financial crises, regulation and growth," NIESR Discussion Papers 313, National Institute of Economic and Social Research.
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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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