Credit Conditions and the Amplification of Macro-economic Responses to Unexpected Shocks: Implications for Monetary Policy

What are the implications of tighter credit conditions on how the repo rate responds to positive inflation shocks? Evidence shows that credit conditions shocks induce less variation in inflation compared to those due to the repo rate shocks. But credit conditions induce more fluctuations in GDP growth compared to the repo rate. Furthermore, we find that tighter credit conditions exert non-linear effects on GDP growth and the effects were accentuated post-2008Q4. GDP growth declines more in the presence of credit conditions compared to when the credit conditions are shut off in the inflation equation. This suggests that tight credit conditions worsen the GDP growth decline due to positive inflation shocks. The amplification effects are not only restricted to positive inflation shock effects. The decline in GDP growth rate is pronounced in the presence of tight credit conditions compared to when these are shut off. Thus, credit conditions play a significant role in GDP growth dynamics as a transmitter of positive inflation and repo rate shocks. Tight credit conditions neutralise (dampen) the effects of the R/US$ exchange rate depreciation shock on inflationary pressures. This has implications for the repo rate response to inflationary pressures. Tight credit conditions and muted GDP growth lead to less aggressive repo rate responses to inflationary pressures. In the absence of credit-driven demand pressures on inflation, tight credit conditions and muted GDP growth have a significant impact on the pace and magnitude of repo rate responses to inflation.