Credit Cycles

The term “credit cycle” refers to cyclical fluctuations in interest rates and credit availability.

During an improving economy, lenders are more willing to extend credit at favorable terms. In contrast, lenders tighten their lending standards in a weak economy by increasing rates and making loans harder to obtain. These factors often lead to the decline of assets such as real estate, resulting in further declines in the economy and higher default rates. Credit plays a large role in financing property acquisition and construction.

Studies suggest that credit cycles coincide with stronger expansions and longer contractions. Credit cycles and business cycles do not always coincide, as historical data suggests the former has lasted on average longer than the latter.

Additionally, the length of credit cycles tends to be longer than that of business cycles. 

Consequences for policy

Investors will pay attention to the stage in the credit cycle for several reasons. Namely:

• It helps them understand developments in the housing and construction markets

• It helps them assess the extent of business cycle expansions as well as contractions.

• It helps them better anticipate policy makers’ actions.

 Macroprudential policies, financial policies aimed at ensuring the stability of the financial system as a whole to prevent substantial disruptions in credit, have gained importance. 

Question

Investors will pay attention to the stage in the credit cycle least likely because:

1. It helps them better anticipate policy makers’ actions.
2. Credit cycles tend to be longer, deeper, and sharper than business cycles.
3. It helps them understand developments in the housing and construction markets.

Solution

The correct answer is B.

Investors do not pay attention to the stage in the credit cycle because credit cycles tend to be longer, deeper, and sharper than business cycles. They do so for the following reasons:

• credit cycle helps them understand developments in the housing and construction markets

• credit cycle helps them assess the extent of business cycle expansions as well as contractions.
• credit cycle helps them better anticipate policy makers’ actions.