Academic journal article Federal Reserve Bank of New York Economic Policy Review

Credit Effects in the Monetary Mechanism. (Session 3: Financial Markets and Institutions)

Academic journal article Federal Reserve Bank of New York Economic Policy Review

Credit Effects in the Monetary Mechanism. (Session 3: Financial Markets and Institutions)

Article excerpt


Monetary transmission is one of the great mysteries in economics. Namely, how can purchases or sales of just a few billion dollars in securities in the overnight reserve market have such large, persistent effects on overall spending? The traditional monetary transmission mechanism--a change in reserves alters interest rates and deposits, which in turn affects spending--begs a number of questions. For one, can a 50-basis-point change in the federal funds rate really make such a difference for investment in inventories, structures, housing, consumer durables, and other "interest-sensitive" sectors? Is it merely that higher interest rates reduce the present value, and hence demand, for such investments? Why does a shock to the federal funds rate leave spending depressed for a year or more after the funds rate returns to its initial level? It is good to acknowledge these "long" lags, but acknowledgment hardly explains them.

Credit effects, neglected in the traditional monetary mechanism, may solve some of the mystery. Given informational frictions in the right markets, tight monetary policy will also cause contractions in bank lending and therefore declines in spending by bank-dependent borrowers. This channel of policy is typically referred to as the narrow bank lending channel, discussed in some detail in Bernanke and Blinder (1988) and Kashyap, Stein, and Wilcox (1993). A second channel, referred to as the balance-sheet mechanism, can exist because tighter monetary policy causes firms' interest payments to rise at a time when revenues are falling, weakening firms' balance sheets and limiting their ability to grow and spend. Moreover, the increased risk of firms shirking their loans in the aftermath of tight policy may also cause the overall supply of funds to fall (Bernanke, Gertler, and Gilchrist 1999). Note that both credit effects--the narrow bank lending channel and the broader balance-sheet mechanism--are endogenous to the monetary policy process yet are completely missing from the mostly frictionless monetary mechanism. (1)

Policymakers at times have also resorted to more direct actions to limit bank credit "availability," such as interest rate ceilings, credit controls, and jawboning (Romer and Romer 1993). In contrast to the credit channels, these actions are not inherent or endogenous to the monetary mechanism; they are ad hoc actions intended to reduce bank loan supply without leading to higher loan rates (for political reasons, or because policymakers view higher rates alone as ineffective in curbing borrowing and spending).

This paper looks for evidence of both types of credit effects--those that are endogenous to the monetary mechanism and those that are exogenous--using information on banks' commercial credit standards as a proxy for bank credit availability. We compare results from an "off-the-shelf" macroeconomic vector autoregression (VAR) model extended to include the commercial loan market. Two different specifications of the loan market are considered: a classical market with the quantity and price (that is, interest rate) on loans and an augmented market with standards included as a proxy for loan availability. We consider first whether gyrations in credit standards are important in explaining loan and output dynamics--that is, do standards "matter" for the macroeconomy? Next, do changes in the stance of monetary policy cause lenders to change their standards? In other words, does monetary policy work in part through lending standards, or are changes in standards independent of policy? Last and most generally, is the impact of monetary policy on output diminished when we account for the impact of standards?

We present three principal findings. First, innovations or unanticipated shocks to standards have a significant impact on both commercial loans and output. Second, standards are not very sensitive to changes in monetary policy, at least not the policy shocks we identify with shocks to the federal funds rate. …

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