What Caused the Recent Boom-And-Bust Cycle in Lithuania? Evidence from a Macromodel with the Financial Sector

In this paper we analyse determinants of the recent boom-and-bust cycle of the Lithuanian economy with the help of a medium-sized macroeconometric model that incorporates a functional financial block. Special emphasis is put on the role of credit market conditions during the overheating episode. We quantitatively estimate the impact of credit conditions and externally funded bank lending on macroeconomic developments. There is evidence that easy credit conditions and active credit expansion contributed moderately to real economic growth but significantly added to overheating pressures by pushing up real estate prices, encouraging concentration of labour and capital into procyclical sectors and increasing private sector’s debt burden. During the boom episode buoyant external environment provided strong background for export-led growth, which was later strongly affected by temporary foreign trade collapse at the outset of the economic crisis. Model results also suggest that government’s discretionary fiscal policies may have contributed to economic overheating and severity of the ensuing crisis by not adopting sufficiently prudent fiscal stance during the boom episode. The model confirms that more favourable interest rate environment and accommodating fiscal policies are important for providing a temporary relief for the crisis-stricken economy but deep structural transformation of the economy is needed for the sustainable recovery to take hold.