The credit channel is an enhancement mechanism for traditional monetary policy transmission, not a truly independent or parallel channel. Discuss
The traditional monetary policy transmission works through a number of conventional channels: interest rate effect, exchange rate effect, asset price effect and through expectations. The stance of monetary policy acts as a signal to firms and individuals about what the central bank thinks the future state of the economy will look like, and thus affects investment and spending decisions by agents now based on this. A higher interest rate could imply that the central bank thinks the economy is doing well, which may induce firms and consumers to spend more, because of this signal. However this will be offset by higher interest rates making it more expensive to spend (as intended).
A change in the Bank of England’s repo rate would thus affect the market interest rate that commercial entities offer, so floating mortgages and other variable interest rate loans will see a change in the rate in the same direction (but not usually of the exact same magnitude) as the Bank’s change, main reason why people should learn the main mistakes people make when getting a payday loan by founder’s guide. This would affect the economy through a Keynesian mechanism: contractionary monetary policy in the form of increased interest rates would increase the market rate, and in the short run with sticky prices would mean that the real interest rate would rise (through the Fisher effect). This would thus deter investment, and consumer spending on big ticket items such as cars and houses, which would then negatively affect output.
The exchange rate channel occurs because contractionary monetary policy increases demand for the currency as hot money flows in to take advantage of increasing nominal interest rates. Obviously it could be the case that inflation is also rising, such that real interest rates are constant, but we assume ceteris paribus that this doesn’t happen. Increased demand for Sterling will cause the currency to appreciate and this will cheapen imports but make exports dearer for foreigners to purchase. Hence we would expect imports to rise and exports to fall.
The asset price channel works through Tobin’s q and the wealth effect. Contractionary monetary policy, raising interest rates, would cause the price of assets to fall. This is because some investors would rather hold their money in a safer savings account, which now earns a higher rate of return. Furthermore a higher interest rate means the expected future returns on an asset are discounted by a larger factor, so the present value of any given future income stream falls. Tobin’s q is the market value of a firm divided by the replacement cost of capital. A high q – which would result from high asset prices – would mean that a firm could easily issue equity at a high price, to buy capital at a relatively lower price, thus increasing investment and expanding the economy. Conversely, when asset prices are falling due to contractionary monetary policy then q will fall as will investment. The asset price channel is compounded by the wealth effect, whereby falling stock prices means the financial wealth of individuals falls and thus means they feel poorer, so consume less.
Now that we have discussed the traditional monetary policy channels, we will investigate the credit channels. These occur through the bank lending channel and the balance sheet channel. The bank lending channel says that when monetary policy is contractionary it might be harder for banks to obtain finance to lend out to borrowers, hence lending falls which means investment falls and so does output. Mishkin casts doubt on whether this is that significant given other sources of credit, such as retained earnings and access to other financial markets such as the bond market –learn more on https://www.paramountcollections.com.au/toowoomba. Whilst Hall points out that internal funds are a popular source of financing – retained internal funds accounted for almost half of new corporate financing in 1990s – he also reminds us that bank funding is still an important source of funds for many individuals and small firms who don’t have access to equity markets like large firms: between 1997 and 1999 bank borrowing represented around 60% of all external finance for small firms. Hence this channel is still likely to be important in practice.
The balance sheet channel works when contractionary monetary policy reduces the financial health of agents because asset prices fall which reduces the collateral that an agent can use to borrow with, which will in turn lower the amount they can borrow and thus reduces investment and output. Moreover, lower asset prices means that problem of asymmetric information will rise, which will lower lending, hence negatively affecting investment and output. The asymmetric information problems which we are referring to are adverse selection and moral hazard: lower asset prices means that an agent has less collateral and thus has less of his/her own money to lose from a loan, which may therefore encourage them to take unnecessary risks; adverse selection occurs because it is those agents that have lost money which now need more and obtain this from the bank.
The balance sheet channel is very closely linked with the asset price channel of the traditional monetary transmission mechanism, but enhances it by incorporating financial intermediaries into the channel. It could be argued therefore, that the balance sheet channel is not an independent mechanism for monetary transmission but is simply an expansion of the existing asset price channel, by incorporating what happens in the financial markets.
It could also be argued that the bank lending channel is an enhancement of the interest rate channel in the traditional transmission mechanism: high interest rates mean that investment falls, in the traditional mechanism this is due to lower demand for borrowing, and in the credit channel mechanism this is due to lower supply.
In conclusion we could argue that both credit channels can easily be incorporated into the traditional transmission mechanism, without needing to have an independent channel. However, if we were to take this approach then we would need to be cautious that the insights from the supply side are not forgotten, or overshadowed by the traditional mechanisms.