Academic journal article Review - Federal Reserve Bank of St. Louis

Financial Innovation, Deregulation and the 'Credit View' Of

Academic journal article Review - Federal Reserve Bank of St. Louis

Financial Innovation, Deregulation and the 'Credit View' Of

Article excerpt

It is generally acknowledged that monetary policy affects real economic activity in the short run and inflation or the price level in the long run, but much less of a consensus exists on exactly how monetary policy affects output and prices. The possibility that monetary policy affects the economy through credit channels has received considerable attention lately. Two distinct credit channels for monetary policy have been described.(1) Both of these channels are based on lending problems associated with asymmetric information and control.(2) The cost of acquiring information and controlling borrower's behavior drives a wedge between the cost of internal and external finance. For some borrowers the premium for external finance is so large that it is impractical for them to obtain funds in impersonal financial markets. Depository financial intermediaries (hereafter, banks), reduce the wedge by specializing in acquiring information about and assessing the risk characteristics of such borrowers.(3)

One broad credit channel has been called the "excess sensitivity hypothesis" by Gertler and Gilchrist (1993b). According to this hypothesis, monetary policy actions induce changes in interest rates and prices that are propagated through their effect on borrowers' balance sheets.(4) For example, restrictive monetary policy may reduce the net worth of borrowers, causing the premiums that small borrowers must pay for external finance to rise. Gertler and Gilchrist point out that this credit channel is operative "even if the central bank has no direct leverage over the flow of bank credit."(5) An alternative credit channel, called the "credit view" of monetary policy by Bernanke and Blinder (1988), Bernanke (1993) and Gertler and Gilchrist (1993b), requires monetary policy actions to have a direct effect on bank lending.

This article outlines the credit view of monetary policy and points out that the conditions that are necessary for it are stringent. Consequently, there is reason to doubt whether the bank lending channel of monetary policy has ever been empirically significant. This article, however, does not attempt to evaluate whether the bank credit channel of monetary policy ever existed. Rather, it points out that financial innovation and deregulation have altered the structure of financial markets in ways that should have weakened the bank credit channel of monetary policy over time. In addition, it points out that the bank credit channel of monetary policy should have been further diminished by the Monetary Control Act of 1980 and subsequent changes in the structure of Federal Reserve reserve requirements that have significantly weakened the link between monetary policy actions and bank lending. Finally, the article presents evidence which suggests a weak and deteriorating relationship between Federal Reserve actions and the supply of bank credit.


The credit view of monetary policy is part of a much broader literature on the role of credit in the macroeconomy. Several recent papers (Bernanke and Blinder, 1988; Bernanke 1993; Gertler and Gilchrist, 1993b; and Kashyap, Stein and Wilcox, 1993) have defined the credit view more precisely within this broader framework. It is now generally understood that the credit view is the idea that monetary policy actions not only affect the economy through their effect on the liability side of banks' balance sheets, that is, by affecting the quantity of money, but also through their direct effect on bank lending.

In this literature, the "monetary view" of monetary policy tends to be rather narrowly focused on interest rates.(6) Proponents of the credit view argue that even under extreme conditions where either interest rates do not respond to monetary policy actions or where spending is unresponsive to changes in interest rates, monetary policy actions affect the economy because of their direct effect on bank loans.(7)

Consequently, proponents of the credit view believe that the effects of monetary policy actions on the economy are larger than those that can be attributed to the effect of monetary policy actions on interest rates alone. …

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