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Definition of Credit Crunch

Many definitions of the term credit crunch have appeared in the literature. 145  In our view, a credit crunch occurs when, for a given price of credit, lenders substantially reduce the volume of credit provided to a group of borrowers whose risk is essentially unchanged. That is, a credit crunch is caused by a reduction in lenders' willingness to make risky investments or by a ''flight to quality'' by lenders. In terms of a standard supply and demand diagram, a credit crunch is a substantial decline in the volume of credit caused mainly by a leftward shift of the credit supply curve, when the shift is not due principally to an increase in the riskiness of borrowers. This definition is similar in spirit to that of Bernanke and Lown (1991), who define a crunch as ''a significant leftward shift in the supply for bank loans, holding constant both the safe real interest rate and the quality of potential borrowers.''

A contraction of supply alone does not necessarily imply a credit crunch, as credit availability may decrease and lending terms tighten because of an increase in the riskiness of borrowers. Thus our definition of a credit crunch does not include a reduction in supply that is a normal response to a recession or an economic slowdown. In such circumstances, the riskiness of borrowers normally increases, and lenders demand compensation either in higher interest rates or in tighter nonprice terms of loans. Although borrowers might characterize such a reduction in credit supply as a credit crunch, such a characterization would not be appropriate because the decrease in credit is a normal response of lenders to changing economic conditions. Cantor and Wenninger (1993) refer to this situation as a ''credit slowdown.'' 146

Our definition of credit crunch differs from some, notably that of Owens and Schreft (1992), in that it does not require that the reduction in credit be accomplished by nonprice rationing. The reduction may be effected entirely by an increase in the relative price of credit, as would normally occur in response to a leftward shift of a supply curve, or by some combination of price increase and nonprice rationing.

  1. See Owens and Schreft (1992) for a review of definitions.

  2. Cantor and Wenninger's definition of credit slowdown would also include a reduction in credit due to a reduction in demand.

Evidence That a Credit Crunch Occured

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