Over the last five years, we have been working on the question of how the effects of monetary policy - that is, open market operations - are transmitted to the economy. The principal theme of our work has been that, in order to fully understand the monetary mechanism, one must move beyond traditional macro explanations that emphasize households' relative preferences for "money" and other less liquid assets. In our view, the role of the commercial banking sector is central to the transmission of monetary policy. More specifically, two key factors shape the way in which monetary policy works: the extent to which banks rely on reservable deposit financing, and hence adjust their loan supply schedules in the wake of open market operations; and the extent to which certain borrowers in the economy are "bank-dependent," and therefore cannot offset these Fed-induced shifts in bank loan supply easily. These two factors in turn depend on the details of the financing arrangements available to both banks and nonfinancial firms, so that our research naturally brings together central issues in corporate finance and macroeconomics.
Our key empirical findings can be summarized briefly by the following picture of monetary policy transmission: when the Fed tightens policy, aggregate lending by banks gradually slows down, and there is a surge in nonbank financing (for example, the use of commercial paper). When this substitution of financing is taking place, aggregate investment is cut back (by more than would be predicted solely on the basis of rising interest rates). Small firms that do not have significant buffer stocks of cash are most likely to trim investment (particularly investment in inventory) around the periods of tight money. Similarly, smaller banks seem more prone than large banks to reduce their lending. Overall, the results suggest that monetary policy may have important real consequences, but not because of standard interest rate effects.
In our first paper, which was co-authored with David Wilcox, we looked at aggregate data. Perhaps the simplest aggregate empirical implication of the bank-centric view of monetary transmission is that banks' loans should be correlated closely with measures of economic activity. In fact, there is a strong correlation between bank loans and unemployment, GNP, and other key macroeconomic indicators, as demonstrated by Bernanke and Blinder.(1) But, in terms of establishing support for a "bank lending channel," such correlations are inconclusive because they could arise even if the lending channel were not operative. For example, it may be that the correlations are driven by changes in the demand for bank loans rather than the supply of bank loans. That is, bank loans and inventories might move together because banks always stand willing to lend, and firms finance desired changes in level of inventories with bank loans.
The main point of the first paper was a way to overcome this fundamental difficulty in separating the role of loan demand from loan supply. Our insight was that movements in substitutes for bank financing should contain information about the demand for bank financing. For example, if bank loans are falling while the issuance of commercial paper is rising, then we infer that the supply of bank loans has contracted.(2) Thus, we examined movements in the "mix" between bank loans and loan substitutes following changes in the stance of monetary policy.(3) Using both the federal funds rate and the Romer and Romer(4) policy proxy as indicators of the stance of monetary policy, we found that when the Fed tightens, the issuance of commercial paper surges while loans (slowly) decline - that is, the change in the mix indicates that loan supply has shifted inward.(5)
Having established that the bank financing mix could be used to infer movements in banks' loan supply, we were able to test whether loan supply affected firms' spending. In other words, we were able to check whether the correlation between lending and spending occurred purely because of movements in loan demand. …