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The Credit Channel And Monetary Transmission Notes

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Economics Part IIA, Paper 2 Macroeconomics Lent Term 2010 Supervision 02: Monetary Transmission Mechanism

"The credit channel is an enhancement mechanism for traditional monetary policy transmission, not a truly independent or parallel channel. Discuss" The credit channel view proposes an additional channel through which monetary policy affect the wider economy. This explanation, also called credit view, proposes two types of transmission channels, namely bank lending and balance sheet effects. The bank lending effect acts through higher bank deposits, caused by an expansionary monetary policy, which in turn increase the amount of loans and stimulate investment and consumption of firms and households dependent on bank loans. On the other hand, the balance sheet channel for firms works in the following way: Expansionary monetary policy raises stock prices, which increases firms' net worth and thus reduces problems of adverse selection and moral hazard. With these issues playing a smaller role, bank lending increases and output rises. Similarly, expansionary monetary policy also improves firms' and households' cash flow through lower interest rates, which improves firms' and households' balance sheets. This makes it easier for lenders to know whether the firm will be able to pay its bills, thereby reducing adverse selection and moral hazard and increasing output. For households, there are also liquidity effects: Loosening monetary policy will make households feeling more secure about their financial position and reducing the risk of financial distress. Therefore, households will be more willing to purchase durables and to increase housing expenditure, as the fear of having to sell these illiquid goods at a substantial discount is reduced. There are several reasons why the credit channel is an important monetary transmission mechanism: First, empirical evidence shows that credit market imperfections crucial to the type of credit channels do affect firms' employment and spending decisions. Second, there is evidence that small firms, which are more likely to be 1

credit constrained, are more affected by monetary tightening than large firms which find it easier to borrow directly from financial markets. Gertler and Gilchrist (1994) have found that small firms contract substantially relative to large firms after tight money and that they account for a significantly disproportionate fall in manufacturing. Third, 2

the asymmetric information view of credit market imperfections as the core of the credit channel has proved useful in explaining many other important phenomena, such as why many of our financial institutions exist, why our financial system has the structure it has, and why financial crises are so damaging to the economy.

3 Concerning the independence of the credit channel, we can look at a model that separates the credit channel and the traditional interest rate channel: The Bernanke Blinder model, an extension to the ISLM model, incorporates the LM curve as the traditional interest rate channel, whereas the CC curve captures the effects of bank lending. In this model, it is theoretically possible that the bank lending channel is impotent, if banks do not increase the amount of loans they give out in response to higher deposits, or if banks were required to have a 100% reserve ratio. However, the traditional interest rate channel will always be effective, regardless of the value of the parameter that determines its strength, the reserve ratio required by the central bank. Therefore, in the sense that the traditional interest rate channel always works, whereas the effectiveness of the bank lending channel depends

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