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

Policy Transmission Policy Transmission Bernake and GertlerBernake and Gertler

IntroductionIntroduction

Why should actions taken by the central bank have Why should actions taken by the central bank have any effect on the external finance premium in credit any effect on the external finance premium in credit markets?markets?

Two possibilities: Two possibilities: a) Balance sheet channel: effect of monetary a) Balance sheet channel: effect of monetary policy on the balance sheet and income policy on the balance sheet and income statements of borrowers.statements of borrowers.b) Bank lending channel: effect of monetary b) Bank lending channel: effect of monetary policy on the supply of loans by financial policy on the supply of loans by financial institutions. institutions.

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

To evaluate the effect of a tightening ofTo evaluate the effect of a tightening ofmonetary policy on the economy, themonetary policy on the economy, theauthors estimate a series of VAR’s, usingauthors estimate a series of VAR’s, usingthe federal funds rate as a proxy for thethe federal funds rate as a proxy for thestance of monetary policy. It is assumedstance of monetary policy. It is assumedthat the shock to the federal funds ratethat the shock to the federal funds raterepresents an unanticipated change inrepresents an unanticipated change inmonetary policy. monetary policy.

The Balance Sheet ChannelThe Balance Sheet Channel Based on the theoretical prediction that the Based on the theoretical prediction that the

external finance premium facing a borrower external finance premium facing a borrower should depend on borrower’s financial position. should depend on borrower’s financial position.

The greater is the borrower’s net worth, the lower The greater is the borrower’s net worth, the lower the external finance premium should be.the external finance premium should be.

Since borrower’s financial position affect the Since borrower’s financial position affect the external finance premium, and thus the overall external finance premium, and thus the overall terms of credit that they face, fluctuations in the terms of credit that they face, fluctuations in the quality of borrowers balance sheets should affect quality of borrowers balance sheets should affect their investment decisions.their investment decisions.

The balance sheet channel of monetary policy The balance sheet channel of monetary policy arises because shifts in FED policy affect not arises because shifts in FED policy affect not only market interest rates per se but also the only market interest rates per se but also the financial position borrowers. financial position borrowers.

The effect on the financial position of borrowers The effect on the financial position of borrowers is direct and indirect:is direct and indirect:

a) Direct: rising interest rates directly a) Direct: rising interest rates directly increase increase interest expenses. interest expenses.

b) Indirect: firm’s revenues decline.b) Indirect: firm’s revenues decline.

The authors proxy the financial position of firms The authors proxy the financial position of firms with the coverage ratio defined as with the coverage ratio defined as

Interest payments/interest payments+profitsInterest payments/interest payments+profits

Increases in the coverage ratio translate into Increases in the coverage ratio translate into weakerweaker

balance sheet positions.balance sheet positions.

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

In addition to the graphical analysis of the In addition to the graphical analysis of the coverage ratio and the federal funds rate, the coverage ratio and the federal funds rate, the authors estimate a VAR considering financial authors estimate a VAR considering financial variables including: interest payments, gross variables including: interest payments, gross income, profits, and employee compensation. income, profits, and employee compensation.

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

The Bank Lending Channel The Bank Lending Channel Monetary policy may also affect the external finance Monetary policy may also affect the external finance

premium by shifting the supply of intermediate credit. premium by shifting the supply of intermediate credit.

A reduction in the supply of bank credit, relative to A reduction in the supply of bank credit, relative to other forms of credit, is likely to increase the external other forms of credit, is likely to increase the external finance premium and to reduce real activity. finance premium and to reduce real activity.

For this channel to work it is sufficient that For this channel to work it is sufficient that contractionary monetary policy increases bank’s cost contractionary monetary policy increases bank’s cost of funds. AN increase in the cost of funds would of funds. AN increase in the cost of funds would decrease the supply of funds. decrease the supply of funds.

To illustrate this channel, the authors graph a To illustrate this channel, the authors graph a variable that measures the cost of obtaining variable that measures the cost of obtaining funds (terms of lending) and variables to proxy funds (terms of lending) and variables to proxy the external finance premium (interest-rate the external finance premium (interest-rate spreads). spreads).

Why interest-rate spreads? Why interest-rate spreads?

Note that the importance of this channel may Note that the importance of this channel may have decreased through out time.have decreased through out time.

Housing and Other Consumer Housing and Other Consumer ExpendituresExpenditures

The authors notice that the credit market frictions The authors notice that the credit market frictions that affect firms should also be relevant to the that affect firms should also be relevant to the borrowing and spending decisions made by borrowing and spending decisions made by households on durable goods.households on durable goods.

To illustrate this point they graph the ratio of To illustrate this point they graph the ratio of mortgage payment to income against the federal mortgage payment to income against the federal funds rate.funds rate.

ConclusionsConclusions By considering the credit channel the analysis shows By considering the credit channel the analysis shows

possible explanations for various puzzles in the possible explanations for various puzzles in the transmission mechanism of monetary policy:transmission mechanism of monetary policy:

a)a) After a tightening of monetary policy, much of the decline After a tightening of monetary policy, much of the decline in both inventories and nonresidential investment occurs in both inventories and nonresidential investment occurs with a lag. The authors argue that this can be explained with a lag. The authors argue that this can be explained by considering the fact that after interest rates increase, by considering the fact that after interest rates increase, the financial position of a firm does not necessarily the financial position of a firm does not necessarily deteriorates immediately. deteriorates immediately.

b)b) The response of long-lived consumer goods. This may be The response of long-lived consumer goods. This may be due to the effect of monetary policy in the external due to the effect of monetary policy in the external finance premium of firms and households. finance premium of firms and households.