Credit boom → Inflation: chain of analysis

ChainWhat it assumes · how to break it

Start

Banks expand mortgage and consumer lending rapidly and relax their lending standards, as many did in the years before 2007.

As a result, households and firms can borrow more cheaply and easily, so consumption and investment rise.
consumption · investment · credit creation

Assumes: Households and firms want to borrow more.

But: Households that are already heavily in debt or pessimistic may use easier credit to refinance existing loans instead of spending more.

In addition, extra mortgage lending drives up house prices, and the positive wealth effect raises consumption further.
asset prices · wealth effect

Assumes: Homeowners spend more when their houses are worth more.

But: Housing wealth cannot be spent unless owners borrow against it or sell, and higher prices raise living costs for those planning to buy.

Therefore, aggregate demand grows faster than productive capacity and a positive output gap opens.
AD · positive output gap

Assumes: The economy starts close to full capacity.

But: If there is a large negative output gap, the extra demand is absorbed by spare capacity.

Consequently, firms raise prices as demand outstrips supply and workers bid up wages, so demand-pull inflation rises.
demand-pull inflation

Best link to attack
Assumes: Extra spending falls on goods and services whose prices are measured in CPI.

But: If much of the credit is spent on existing houses and financial assets, it raises asset prices far more than consumer prices.

End

Demand-pull inflation rises as credit-fuelled spending outstrips productive capacity, with asset price inflation alongside.

Evaluation chainattacks link 4 · Assumptions

E1However, the rise in inflation depends on where the extra credit is spent.
E2If most of the extra lending is spent on existing houses and financial assets, it raises asset prices more than the prices of goods and services.
E3As a result, consumer price inflation can stay near target while house prices rise rapidly, as in the UK in the years before 2007.
E4So a credit boom may show up as asset price inflation more than CPI inflation, which is why the Bank of England's Financial Policy Committee now watches credit and house prices directly.

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Assess the impact of rapid growth in bank lending on inflation.
Evaluate whether central banks should respond to rising house prices as well as consumer price inflation.
Discuss the extent to which a credit boom causes demand-pull inflation.

AD/AS: AD shifts right towards or beyond full capacity, so the price level rises with little extra output.

Credit crunch → spending and AD fall and inflation falls.

GCSE version