Inside the Black Box: The Credit Channel of Monetary Policy Transmission

Abstract

M ost economists would agree that, at least in the short run, monetary policy can significantly influence the course of the real economy. Indeed, a spate of recent empirical research has confirmed the early finding of Friedman and Schwartz (1963) that monetary policy actions are followed by movements in real output that may last for two years or more (Romer and Romer, 1989;Bernanke and Blinder, 1992; Christiano, Eichenbaum and Evans, 1994a,b). There is far less agreement, however, about exactly how monetary policy exerts its influence: the same research that has established that changes in monetary policy are eventually followed by changes in output is largely silent about what happens in the interim. To a great extent, empirical analysis of the effects of monetary policy has treated the monetary transmission mechanism itself as a "black box."Of course, conventional views of how monetary policy works are readily available. According to many textbooks, monetary policymakers use their leverage over short-term interest rates to influence the cost of capital and, consequently, spending on durable goods, such as fixed investment, housing, inventories and consumer durables. In turn, changes in aggregate demand affect the level of production. But the textbook story is incomplete in several important ways.One problem is that, in general, empirical studies of supposedly "interestsensitive" components of aggregate spending have in fact had great difficulty in identifying a quantitatively important effect of the neoclassical cost-of-capital variable.1 Indeed, the most common finding is that nonneoclassical factors-for example, 1 In a frictionless market, the usual Jorgensonian formula for the neoclassical cost of capital, ignoring expected price changes, is (r + d)p k , where r is the required real return to lenders (which could include a premium for systematic risk), d is the depreciation rate and p k is the price of a new capital good.

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“…Bernanke and Gertler (1989) prove that the external finance premium and the net worth (the balance sheet strength) of the borrower are inversely related. When monetary policy tightens, the balance sheet constraints of borrowers increase and their creditworthiness decreases because the interest expenses from the existing borrowings increase and the net cash flow decreases (Bernanke and Gertler, 1995;Boivin et al, 2010). The net worth of borrowers is pro-cyclical and amplifies the business-cycle fluctuations (a phenomenon called the financial accelerator).…”

“…The net worth of borrowers is pro-cyclical and amplifies the business-cycle fluctuations (a phenomenon called the financial accelerator). During economic or financial shocks to the economy, the frictions in the credit market increase, consequently increasing the external finance premium (Bernanke and Gertler, 1995;Bernanke, 2007). During these times, or in countries with greater information asymmetry problems (Markovic, 2006), the transmission of monetary policy impulses to the economy through the broad credit channel is expected to be amplified (Ciccarelli et al, 2015).…”

“…During these times, or in countries with greater information asymmetry problems (Markovic, 2006), the transmission of monetary policy impulses to the economy through the broad credit channel is expected to be amplified (Ciccarelli et al, 2015). 8 Empirical studies that find the broad credit channel operational in the transmission of monetary policy impulses to the economy include, among others, Gilchrist (1993, 1994), Kashyap et al (1993), Cecchetti (1995), Bernanke and Gertler (1995), Oliner and Rudebusch (1996), Warner and Georges (2001), Hatzius (2005), Benito et al (2006), and Christensen and Dib (2008). Studies that investigate the broad credit channel in the euro area and to which our study is related include Ciccarelli et al (2013Ciccarelli et al ( , 2015.…”

“…Bernanke and Gertler, 1995;Markovic, 2006;Bernanke, 2007;Van den Heuvel, 2007) and empirical evidence (Ciccarelli et al, 2013(Ciccarelli et al, , 2015. It is worth stressing that euro area banks see a contractionary monetary policy shock having a greater negative impact on the borrowers' balance sheets than on the banks' capital position.…”

Panel Data Analysis of Monetary Transmission Mechanism for European Union Countries

“…Bernanke and Gertler (1995) have shown how difficult it is to explain the response of economy on monetary shock through interest rate channels in their study and studied on credit channel. Gerlach and Smets (1995) searched the monetary transmission mechanism for G-7 countries with VAR analysis.…”