Inside the Black Box: The Credit Channel of Monetary Policy Transmission

1. Inside the Black Box: The Credit Channel of Monetary Policy Transmission Bernake and Gertler

2. Introduction • Why should actions taken by the central bank have any effect on the external finance premium in credit markets? • 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 institutions.

3. Evidence from Vector Autoregressions (VAR’s) 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.

7. The Balance Sheet Channel • Based on the theoretical prediction that the external finance premium facing a borrower should depend on borrower’s financial position. • The greater is the borrower’s net worth, the lower the external finance premium should be. • 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.

8. 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 borrowers. • 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.

9. 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. • The relationship between the coverage ratio and the federal funds rate is the following:

11. 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 compensation. • The VAR models a positive one standard deviation of the federal funds rate.

13. The Bank Lending Channel • Monetary policy may also affect the external finance premium by shifting the supply of intermediate credit. • 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. • 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.

14. 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). • Why interest-rate spreads? • Note that the importance of this channel may have decreased through out time.

16. Housing and Other Consumer Expenditures • 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 goods. • To illustrate this point they graph the ratio of mortgage payment to income against the federal funds rate.

18. Conclusions • By considering the credit channel the analysis shows possible explanations for various puzzles in the transmission mechanism of monetary policy: • 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. • 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.