How Central Banks can affect the Economy - Nicoló Patti
How Central Banks can affect the Economy Nicoló Patti

The conventional theory according to which interest rate effects explain the impact of monetary policy on spending on durable assets does not convince everybody, this dissatisfaction has led to a new explanation, the “Credit View”, based on the concept of asymmetric information and on the financial frictions caused in the markets by this asymmetry.

In fact, the credit view proposes that the financial friction in credit markets fosters the rise of two types of monetary transmission channels:

· Bank Lending Channel: This is based on the ability of banks in solving problems related to asymmetric information in credit markets. In fact, banks are considered to be the best suited, in the financial world, to solve problems related to the asymmetry of information, because, for most players, they are usually the only source to have access to credit.

Therefore, relying on this established situation, monetary policy actions may affect the supply of funds available for banks to loan, and banks serve as a screening agent in order to determine the credit-worthiness of possible borrowers.

Hence, in this situation, an expansionary monetary policy that increases the level of loanable funds available to banks may lead to an increase in loans and therefore to an increase in investments and a rise in consumer spending.

Clearly, these measures will have their greatest effects upon the behavior of small firms, which are more dependent on bank loans than larger firms, which may look for funds even on the stock and bond markets.

· Balance Sheet Channel: It arises (like the bank lending channel) from the presence of financial frictions in credit markets. These financial frictions depend on the fact that lending to firms with a low net worth holds more severe problems of adverse selection and moral hazard. Lower net worth means that lenders have less collateral for their loans, so their potential losses from adverse selection are higher.

A decline in firms’ net worth, which raises the adverse selection problem, leads to decreased lending to finance investment spending. Moreover, the lower net worth of businesses also increases the moral hazard problem because it means that owners have a lower equity stake in their firms, giving them more incentive to engage in risky investment projects.

When borrowers do so, it is more likely that lenders will not be paid back, and so a decrease in businesses’ net worth leads to a reduction in lending and hence in investment spending. In this situation, monetary policy can affect firms’ balance sheets in many different ways, in fact, an easing in monetary policy which leads to a rise in stock prices leads to higher investment spending and higher aggregate demand because of the decrease in adverse selection and moral hazard problems.

· Cash Flow Channel: It is based on the concept that an increase in cash flow (difference between firms’ cash receipts and cash expenditures), caused by an easing of monetary policy, leads to an increase in firms’ (or households’) liquidity and makes it easier for lenders to know whether the firm (or household) will be able to pay back its liabilities. This results in lower adverse selection and moral hazard, and an increase in lending and economic activity.

· Unanticipated Price Level Channel: Focuses upon monetary policy effects on the general price level. In a situation where debt payments are contractually fixed in nominal terms, a rise in inflation, due for example to an easing of monetary policy, lowers the value of the firm’s liabilities in real terms but should not lower the real value of the firms’ assets. Therefore real net worth rises, leading to a reduction in adverse selection and moral hazard, thus encouraging an increase in investment spending and of aggregate demand.

· Household Liquidity Effects: While studying this phenomenon usually the focus is on businesses’ spending habits, while, however, the credit view should apply equally well to consumer spending, particularly directed toward consumer durables and housing.

In fact, in the liquidity effects view, balance sheet effects work through their impact on consumers’ desire to spend rather than on lenders’ desire to lend, therefore, if consumers expect to suffer financial losses as in the case of a severe income shock, they will prefer to hold fewer illiquid consumer durable and housing assets and a greater amount of liquid financial assets.

The illiquidity of consumer durable and housing assets provides another reason why a monetary easing, which lowers interest rates and thereby increases cash flow to consumers, leads to a rise in spending on consumer durables and housing.

Why are Credit Channels Likely to be important?

First, a large body of evidence on the behavior of individual firms supports the view that financial frictions of the type crucial to the operation of credit channels do affect firms’ employment and spending decisions.

Second, evidence shows that small firms (which are more likely to be credit-constrained) are hurt more by tight monetary policy than large firms, which are unlikely to be credit-constrained.

Third, and maybe most compelling, the asymmetric information view of financial frictions, which is at the core of credit channel analysis, is a theoretical construct that has proved useful in explaining many other important economic phenomena, such as why many of our financial institutions exist, why our financial system has the structure that it has, and why financial crises are so damaging to the economy.

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