Question

Discuss the following statements: In a context of tight credit constraints, the credit channel may be critical to the whole process of (conventional) monetary policy transmission in the short term.

Answer 1

The existence of a credit channel in the process of transmission of monetary impulses is a recurrent topic in the literature on the effects of monetary policy. Nevertheless, macroeconomic models have frequently tended to ignore this channel of transmission and empirical tests of its existence have usually been unsatisfactory. Over the past decade, a large number of papers, mainly about the US economy, have helped to correct the traditional assumption that credit is relatively unimportant in the monetary transmission mechanism. They have also provided new empirical approaches to test the existence of this credit channel.

Conventional wisdom regarding the effects of monetary policy on the real economy has concentrated on the so-called money channel, using models based on two financial assets (money and bonds). Under this approach, in the event of an alteration in the supply of money in a given economy, equilibrium will be restored by changes in the interest rate for bonds that will ultimately have an effect on real variables. This approach implicitly assumes that there is only one alternative asset to money (or that all alternative assets are perfect substitutes) and may therefore reflect a partial view of the monetary transmission mechanism. Such a partial approach could lead to erroneous conclusions regarding the degree of effectiveness of monetary policy or the usefulness of the different variables as intermediate targets.

An exhaustive study of how monetary impulses are transmitted requires consideration of the credit channel. The literature uses this term to refer to two different, albeit related, transmission processes. First, in accordance with the bank lending channel (or credit channel in the strict sense) - represented in models based on three assets: money, bonds and bank loans (see, for instance, Bemanke and Blinder (1988)) - the effects of monetary policy are not just via its impact on interest rates for open market transactions but also the result of its independent impact on the supply of bank loans. Secondly, the balance-sheet channel (or credit channel in the broad sense) refers to the additional effects of monetary policy on the final variables through variations in the net financial income received by agents and on their net wealth. Based on more extensive studies by Bemanke (1993), Kashyap and Stein (1994) and Gertler and Gilchrist (1993), this paper describes the theoretical grounds supporting the existence of the credit channel, distinguishing between the two senses of the term.

Consideration of the credit channel contributes to a fuller understanding of the response of output and of demand components to monetary policy measures. Kashyap and Stein (1994), for instance, list a number of reasons why it is important to take the existence of a credit channel into account. One is that the credit channel supports the existence of a different impact of monetary policy depending on agents' degree of access to capital markets. For their part, van Ees et al. (1994) present a model - comprising two types of firm, local and international, with the former lacking access to public capital markets - where the credit channel may even play an effective role in a small, open economy with fixed exchange rates and high international mobility of capital.

The credit channel should not be envisaged as an isolated, independent path, but rather as just another component in the complex workings of the mechanism for monetary policy transmission. As Bernanke and Gertler (1995) point out, the credit channel should be considered a mechanism that reinforces the traditional money channel. How important it is depends on various factors conditioning the relationship between the monetary authority's interventions and economic agents' expenditure decisions. Two such factors that are worth noting are, on the one hand, the institutional framework governing the financial system and, on the other, economic agents' financial position. Regarding the former, the extent to which the banking system acquires liabilities that are not subject to reserve requirements and the role played by non-bank intermediaries are key determinants of the relative importance of the credit channel. Related to this point, there are also implications for the implementation of the single monetary policy in the European Union. Along this line, Dombusch et al. (1997) suggest that monetary policy shocks could have different effects across member countries depending on their financial structures. Regarding the second above-mentioned factor, as Peñalosa (1996) analyses in some detail, economic agents' financial position has a decisive influence on the transmission of monetary impulses. In this sense, the financial health of economic agents, insofar as it determines their degree of access to credit and the terms under which it is granted, affects the relative importance of the credit channel.