Inside the Black Box: The Credit
Channel of Monetary Policy
Bernake and Gertler
n Why should actions taken by the central bank have any
effect on the external finance premium in credit
n Two possibilities:
a) Balance sheet channel: effect of monetary
policy on the balance sheet and income
statements of borrowers.
b) Bank lending channel: effect of monetary
policy on the supply of loans by financial
Evidence from Vector Autoregressions
To evaluate the effect of a tightening of
monetary policy on the economy, the
authors estimate a series of VAR’s, using
the federal funds rate as a proxy for the
stance of monetary policy. It is assumed
that the shock to the federal funds rate
represents an unanticipated change in
The Balance Sheet Channel
n Based on the theoretical prediction that the external
finance premium facing a borrower should depend on
borrower’s financial position.
n The greater is the borrower’s net worth, the lower the
external finance premium should be.
n Since borrower’s financial position affect the external
finance premium, and thus the overall terms of credit
that they face, fluctuations in the quality of borrowers
balance sheets should affect their investment decisions.
n The balance sheet channel of monetary policy arises
because shifts in FED policy affect not only market
interest rates per se but also the financial position
n The effect on the financial position of borrowers is
direct and indirect:
a) Direct: rising interest rates directly increase
b) Indirect: firm’s revenues decline.
n The authors proxy the financial position of firms with the
coverage ratio defined as
Interest payments/interest payments+profits
Increases in the coverage ratio translate into weaker
balance sheet positions.
n The relationship between the coverage ratio and the
federal funds rate is the following:
n In addition to the graphical analysis of the coverage ratio
and the federal funds rate, the authors estimate a VAR
considering financial variables including: interest
payments, gross income, profits, and employee
n The VAR models a positive one standard deviation of the
federal funds rate.
The Bank Lending Channel
n Monetary policy may also affect the external finance
premium by shifting the supply of intermediate credit.
n A reduction in the supply of bank credit, relative to other
forms of credit, is likely to increase the external finance
premium and to reduce real activity.
n For this channel to work it is sufficient that
contractionary monetary policy increases bank’s cost of
funds. AN increase in the cost of funds would decrease
the supply of funds.
n To illustrate this channel, the authors graph a variable
that measures the cost of obtaining funds (terms of
lending) and variables to proxy the external finance
premium (interest-rate spreads).
n Why interest-rate spreads?
n Note that the importance of this channel may have
decreased through out time.
Housing and Other Consumer
n The authors notice that the credit market frictions that
affect firms should also be relevant to the borrowing and
spending decisions made by households on durable
n To illustrate this point they graph the ratio of mortgage
payment to income against the federal funds rate.
n By considering the credit channel the analysis shows possible
explanations for various puzzles in the transmission mechanism of
a) After a tightening of monetary policy, much of the decline in both
inventories and nonresidential investment occurs with a lag. The
authors argue that this can be explained by considering the fact
that after interest rates increase, the financial position of a firm
does not necessarily deteriorates immediately.
b) The response of long-lived consumer goods. This may be due to
the effect of monetary policy in the external finance premium of
firms and households.