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

Is There a "Credit Channel" for Monetary Policy?

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

Is There a "Credit Channel" for Monetary Policy?

Article excerpt

Understanding the channels through which monetary policy affects economic variables has long been a key research topic in macroeconomics and a central element of economic policy analysis. At an operational level, a "tightening" of monetary policy by the Federal Reserve implies a sale of bonds by the Fed and an accompanying reduction of bank reserves. One question for debate in academic and public policy circles in recent years is whether this exchange between the central bank and the banking system has consequences in addition to those for open market interest rates. At the risk of oversimplifying the debate, the question is often asked as whether the traditional interest rate or "money view" channel presented in most textbooks is augmented by a "credit view" channel.(1)

There has been a great deal of interest in this question in the past several years, motivated both by developments in economic models (in the marriage of models of informational imperfections in corporate finance with traditional macroeconomic models) and recent events (for example, the so-called credit crunch during the 1990-91 recession).(2) As I elaborate below, however, it is not always straightforward to define a meaningful credit view alternative to the conventional interest rate transmission mechanism. Similar difficulties arise in structuring empirical tests of credit view models.

This paper describes and analyzes a broad, though still well-specified, version of a credit view alternative to the conventional monetary transmission mechanism. In so doing, I sidestep the credit view language per se, and instead focus on isolating particular frictions in financial arrangements and on developing testable implications of those frictions. To anticipate that analysis a bit, I argue that realistic models of "financial constraints" on firms' decisions imply potentially significant effects of monetary policy beyond those working through conventional interest rate channels. Pinpointing the effects of a narrow "bank lending" channel of monetary policy is more difficult, though some recent models and empirical work are potentially promising in that regard.

I begin by reviewing the assumptions and implications of the money view of the monetary transmission mechanism and by describing the assumptions and implications of models of financial constraints on borrowers and models of bank-dependent borrowers. The balance of the article discusses the transition from alternative theoretical models of the transmission mechanism to empirical research, and examines implications for monetary policy.


Before discussing predictions for the effects of alternative approaches on monetary policy, it is useful to review assumptions about intermediaries and borrowers in the traditional interest rate view of the monetary transmission mechanism. In this view, financial intermediaries (banks) offer no special services on the asset side of their balance sheet. On the liability side of their balance sheet, banks perform a special role: The banking system creates money by issuing demand deposits. Underlying assumptions about borrowers is the idea that capital structures do not influence real decisions of borrowers and lenders, the result of Modigliani and Miller (1958). Applying the intuition of the Modigliani and Miller theorem to banks, Fama (1980) reasoned that shifts in the public's portfolio preferences among bank deposits, bonds or stocks should have no effect on real outcomes; that is, the financial system is merely a veil.(3)

To keep the story simple, suppose that there are two assets--money and bonds.(4) In a monetary contraction, the central bank reduces reserves, limiting the banking system's ability to sell deposits. Depositors (households) must then hold more bonds and less money in their portfolios. If prices do not instantaneously adjust to changes in the money supply, the fall in household money holdings represents a decline in real money balances. …

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