Question

.According to the credit channel theory of monetary policy transmission, how does expansionary monetary policy affect adverse selection problems in credit markets? Explain.  

Answer 1

The credit channel mechanism of monetary policy describes the theory that a central bank's policy changes affect the amount of credit that banks issue to firms and consumers for purchases, which in turn affects the real economy.

According to the credit channel theory, the direct effects of monetary policy on interest rates are amplified by endogenous changes in the external finance premium, which is the difference in cost between funds raised externally (by issuing equity or debt) and funds generated internally (by retaining earnings)

Monetary policy works in part by altering credit flows. The use of legal reserve requirements provide monetary authorities with considerable leverage over the quantity of funds that banks may maintain, just as open market sales reduces the real quantity of deposits banks can issue

The credit channel of monetary policy transmission is an indirect amplification mechanism that works in tandem with the interest ratechannel. The credit channel affects the economy by altering the amount ofcredit firms and/or households have access to in equilibrium.