Inside the Black Box_ The Credit Channel of Monetary Policy

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					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
monetary policy.
      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
       interest expenses.
       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
     monetary policy:
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.

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