Department of Economics

DO BANKS MATTER? A CREDIT VIEW MODEL FOR SMALL OPEN ECONOMIES

Department of Economics

University of Delaware

Working Paper #2003-13

DO BANKS MATTER? A CREDIT VIEW MODEL FOR SMALL OPEN ECONOMIES

Burton A. Abrams, Margaret Z. Clarke, and Russell F. Settle

ABSTRACT

The Mundell-Fleming model is expanded to include a "credit channel" by adding a market for bank loans. In contrast to the predictions of the traditional Mundell-Fleming model, asset shifts in bank portfolios between bonds and bank loans produce aggregate demand effects in our credit-channel model. We test this hypothesis with an empirical growth model estimated with data from small open economies: the U.S. states. The evidence supports our "credit view" model's prediction that variations in bank lending decisions can produce economically significant fluctuations in aggregate demand, and may initiate or amplify economic contractions and expansions.

JEL Classification Numbers: E32, E51

Keywords: Bank Lending; Credit; Credit Channel; Economic Growth x

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