Essay: The credit channel is an enhancement mechanism for traditional monetary policy

transmission, not a truly independent or parallel channel. Discuss.

NOTES

The credit channel mechanism of monetary policy describes the theory that a central bank's
policy changes affect the amount of credit that banks issue to firms and consumers for
purchases, which in turn affects the real economy.

By contrast, the credit channel of monetary policy transmission is an indirect amplification

mechanism that works in tandem with the interest rate channel. The credit channel affects
the economy by altering the amount of credit firms and/or households have access to in
equilibrium. Factors that reduce the availability of credit reduce agents' spending and
investment, which leads to a reduction in output. In short, the main difference between the
interest rate channel and the credit channel mechanism is how spending and investment
decisions change due to monetary policy changes.

The external finance premium is a wedge reflecting the difference in the cost of capital
internally available to firms (i.e. retaining earnings) versus firms' cost of raising capital
externally via equity and debt markets. The external finance premium is a wedge reflecting
the difference in the cost of capital internally available to firms (i.e. retaining earnings)
versus firms' cost of raising capital externally via equity and debt markets.

The credit channelor, equivalently, changes in the external finance premiumcan occur
through two conduits: the balance sheet channel and the bank lending channel.

Balance Sheet Channel

The balance sheet channel theorizes that the size of the external finance premium should be
inversely related to the borrower's net worth. Higher net worth agents may have more
collateral to put up against the funds they need to borrow, and thus are closer to being fully
collateralized than low net worth agents. As a result, lenders assume less risk when lending
to high-net-worth agents, and agency costs are lower.

The balance sheet channel can also manifest itself via consumer spending on durables and
housing. These types of goods tend to be illiquid in nature. If consumers need to sell off
these assets to cover debts they may have to sell at a steep discount and incur losses.
Consumers who hold more liquid financial assets such as cash, stocks, or bonds can more
easily cope with a negative shock to their income. Consumer balance sheets with large
portions of financial assets may estimate their probability of becoming financially distressed
as low and are more willing to spend on durable goods and housing. Monetary policy
changes that decrease the valuation of financial assets on consumers' balance sheets can
result in lower spending on consumer durables and housing.
Bank Lending Channel

If the supply of loanable funds banks possess is affected by monetary policy changes, then
so too should be the borrowers who are dependent on banks' funds for business operations.
Firms reliant on bank credit may either be shut off from credit temporarily or incur
additional search costs to find a different avenue through which to obtain credit. This will
increase the external finance premium, consequently reducing real economic activity.

Bernanke, Gertler (1995)

We don't think of the credit channel as a distinct, free-standing alternative to the traditional
monetary transmission mechanism, but rather as a set of factors that amplify and propagate
conventional interest rate effects. For this reason, the term "credit channel" is something of
a misnomer; the credit channel is an enhance- ment mechanism, not a truly independent or
parallel channel.

This wedge, which we call the external finance premium, reflects the deadweight costs
associated with the principal-agent problem that typicallyex- ists between lenders and
borrowers.

In particular, the greater is the borrower's net worth-defined operation- ally as the sum of
her liquid assets and marketable collateral-the lower the external finance premium should
be.

Intuitively, a stronger financial position (greater net worth) enables a borrower to reduce
her potential conflict of interest with the lender, either by self-financing a greater share of
her investment project or pur- chase or by offering more collateral to guarantee the
liabilities she does issue.

An extensive theoretical literature has exploited this idea to argue that endogenous pro-
cyclical movements in borrower balance sheets can amplify and propagate business cycles,
a phenomenon that has been referred to as the "financial accelerator.

For example, a tight monetary policy directlyweakens borrowers' balance sheets in at least
two ways. First, to the extent that borrowers have outstanding short-term or floating-rate
debt, rising interest rates directly increase interest expenses, reduc- ing net cash flows and
weakening the borrower's financial position.

Second, rising interest rates are also typically associated with declining asset prices, which
among other things shrink the value of the borrower's collateral.

If a monetary tightening reduces spending by those customers (either for cost-of- capital or
balance sheet reasons), the firm's revenues will decline while its various fixed or quasi-fixed
costs (including interest and wage payments) do not adjust in the short run. The resulting
increase in the "financing gap" (the difference be- tween the firm's uses and sources of
funds) erodes the firm's net worth and cred- itworthiness over time.
Further, a number of studies have found that for firms with imperfect access to credit,
move- ments in the coverage ratio have a significant effect on factor demands.
the ratio of interest payments by nonfinancial cor- porations to the sum of interest
payments and profits

Firms that have relatively poor access to credit markets may have to respond to declining
cash flows by cutting production and employment, while firms with good access to credit
will face less financial pressure.

Gertler and Gilchrist (1993, 1994) found striking differences in behavior be- tween large and
small firms. Larger firms, who are more likely to have recourse to commercial paper markets
and other sources of short-term credit, typicallyrespond to an unanticipated decline in cash
flows by increasing their short-term borrowing. The inventories of large firms grow
following a tightening of monetary policy, sug- gesting that these firms are at least
temporarily able to maintain their levels of production and employment in the face of
higher interest costs and declining rev- enues.'4 In contrast, small firms-who in most cases
have more limited access to short-term credit markets-respond to the cash flow squeeze
principally by decu- mulating inventories, that is, by cutting work-hours and production.
Apparently, small firms are not able to increase short-term borrowing.

The bank Lending Channel

If the supply of bank loans is disrupted for some reason, bank-dependent borrowers (small
and medium-sized businesses, for example) may not be literally shut off from credit, but
they are virtually certain to incur costs associated with finding a new lender, establishing a
credit relationship and so on.

Bernanke and Blinder's (1988) model of the bank lending channel suggested that open
market sales by the Fed, which drain reserves and hence deposits from the banking
system,would limit the supply of bank loans by reducing banks' access to loanable funds.

since about 1980, as emphasized by Romer and Romer (1990), banks' ability to raise funds
on the margin-in particular, through issuance of large CDs and other "managed liabilities"-
has become less restricted.

It is extremely difficult to carry out an empirical test that would conclusively separate the
bank lending channel from the balance sheet channel. For this reason, we are more
confident in the existence of a credit channel in general than we are in our ability to
distinguish sharply between the two mechanisms of the credit channel.

Consumers

His "mortgage burden" vari- able, which is (approximately) the ratio of mortgage
payments to income for the median new home buyer, can be considered analogous to the
coverage ratio for firms. Boldin found that the mortgage burden significantly influences
housing de- mand, after controlling for both conventional neoclassical factors and
variables that capture disintermediation effects (as in Ryding's study).