the cost of borrowing and credit rationing is likely to lead businesses and households to shelve some investments or current expenditures for which funding is no longer available or has become too costly.

# **Box.1 DEFINING CREDIT CRUNCH**

"Credit crunch" as a concept is often ill-defined and casually employed. Many people use the term "credit crunch" loosely and in an interchangeable way to describe a variety of phenomena including "tightening of monetary policy", "shortage in the supply of funds", and "credit rationing by banks" etc. Even in the literature concerning credit crunch, there doesn't appear to be a general consensus on a precise definition for the "credit crunch" concept. It is, therefore, useful to explore more carefully the concept of "credit crunch" and to differentiate various terms describing credit conditions, particularly the difference between _credit slowdown_ and _credit crunch._ _A credit slowdown_ can be defined as a general decline in credit growth that may have been generated by either demand or supply factors, or both. Broad changes in the demand for credit may be cyclical (varying with the pace of economic activity) or structural (induced by changes in the tax code etc.). Credit supply can be influenced by changes in financial regulations, structures, and institutions. Monetary policy and autonomous shifts in lender and borrower psychology will have an impact on both credit supply and demand.

Unlike _credit slowdown,_ which is a fairly general term, _credit crunch_ specifically refers to a reduction in the available supply of credit. During a period of credit crunch, lenders become reluctant to lend either because of funding problems stemming from disintermediation, or because regulators have urged credit restraint The reluctance to lend may also stem from the lenders' own balance sheet weaknesses (capital constraints) and their reassessment of borrowers' average credit quality. Although credit crunches are often deemed as primarily supply phenomena, it is difficult to disentangle supply from demand effects since some of the same factors that reduce the willingness to lend may also restrain the desire to borrow.

_A credit crunch_ implies changes in the relationship between credit availability and interest rates: (i) less credit may be available over a wide range of interest rates -- a condition consistent with a leftward shift in a credit supply schedule, or (ii) the reduction in credit availability may bear little relation to the level of rates -- a condition that takes place when allocation occurs via non-price mechanisms. Since credit is normally allocated across potential borrowers by the interest rate, the term credit rationing is commonly used for situations in which the supply of credit is allocated through non-price mechanisms. In general, credit rationing episodes are considered to be a subset of credit crunches in which the interest rate is not the price underlining the credit allocation mechanism. Credit crunches that are characterized by credit rationing may be difficult to alleviate through monetary policy alone.

Source: _Draws on Federal Reserve Bank of New York Quarterly Review, Spring 1993._ 7