Credit, inflation, and the supply side: a theory and global evidence from a new LRAS-leaning barometer

Purpose Why does credit expansion support capital accumulation in some economies while generating inflationary pressures and financial instability in others? This paper examines the institutional heterogeneity of credit transmission mechanisms across developed and developing economies from 1995 to 2024. The study examines whether the macroeconomic effects of credit depend on the efficiency with which financial systems allocate liquidity toward productive investment. Design/methodology/approach The paper develops a theoretical framework in which the macroeconomic impact of credit is determined by an allocative efficiency parameter that reflects institutional quality. Empirically, we introduce the long-run aggregate supply–leaning barometer (LLB), a metric that compares the cumulative responses of investment and inflation to credit shocks. Using local projection methods on a global panel of economies, the analysis estimates the heterogeneous supply-side and inflationary effects of credit expansion. Findings The results reveal substantial cross-country variation in the macroeconomic transmission of credit. In transition economies and capital-scarce developing regions, credit expansion often relaxes supply constraints and generates disinflationary effects through increased capital formation. In contrast, in several regions credit expansion increasingly fuels demand pressures rather than productive capacity. The analysis also identifies a global decline in the LLB after 2010, indicating a growing decoupling between financial deepening and real investment. Research limitations/implications The study relies on aggregate macro-data, which may mask sector-specific nuances. Future research could benefit from granular loan-level data to further unpack the specific channels of credit misallocation. Practical implications The findings suggest that financial reforms must pivot from simply expanding credit access (financial depth) to improving the allocative architecture (quality) of banking systems. This is critical for policymakers aiming to prevent inflationary boom-bust cycles and foster sustainable growth. Social implications The research highlights how misallocated credit fuels asset bubbles and inflation, which act as a regressive tax on lower-income households, rather than fostering productive capacity. By identifying a disinflationary “working capital” channel in developing regions, the findings underscore the societal value of banking reforms. Shifting from speculative finance to production-oriented lending can mitigate cost-of-living pressures and promote stable employment growth, particularly in transition economies where financial instability disproportionately impacts vulnerable populations. Originality/value This paper contributes to the macro-financial literature by proposing a theoretical mechanism linking credit allocation efficiency to supply-side outcomes and by introducing a novel empirical indicator that measures whether credit expansion shifts long-run productive capacity or primarily generates inflationary pressures.