Credit and Economic Activity: Shocks or Propagation Mechanism?-

Abstract In many models with imperfect capital markets, credit plays an important role in the propagation of shocks. Furthermore, this propagation mechanism often implies nonlinear dynamics in the form of asymmetry and regime switching. In this paper, we examine empirically whether credit plays a separate role as a propagator of shocks. We model this propagation empirically as a threshold model in which the dynamics of output grouth changes if the commercial paper/heasury bill spread exceeds a critical threshold. We test and estimate both a single equation threshold model for output growth and a threshold vector autoregression that includes output growth, inflation, a monetary variable, and the paper-bill spread and find evidence of a threshold structure. Using nonlinear impulse response firnctions, we evaluate the dynamics implied by the threshold model. These suggest that money and paper-bill shocks have a larger effect on output in the "tight " credit regime than is normally tle case and that negative money shocks typically have a larger effect than positive shocks. Finally, using a nonlinear version of historical decompositions, we examine post-1960 macroeconomic history throueh the lens of our threshold vector autoresression. Key words: credit, threshold, vector autoregression, nonlinear impulse response * A previous version of this paper was presented at the November 1994 Southern Economi