THE CREDIT CHANNEL OF MONETARY

THE CREDIT CHANNEL OF MONETARY POLICYAccording to some economists, besides working through interestrates and exchange rates, monetary policy also affects creditsupply and demand. These effects are called the credit channel ofmonetary policy. On the supply side of the credit market, accordingto this theory, tight monetary policy leads to reduced lending bybanks. The reason is that, a tightening of monetary policy reducesbank reserves and thus the quantity of customer deposits that bankscan accept. With fewer deposits on hand, banks have a smallerquantity of funds available to lend. As banks cut back on theirlending, the argument goes, borrowers who depend on banks forcredit, such as consumers and small firms, are unable to obtain thecredit they need to make planned purchases. The resulting declinein spending depresses aggregate demand and thus economicactivity.

On the demand side of the credit market, according to proponents ofthe credit channel, tight monetary policy has the effect of makingpotential borrowers less “credit-worthy,” or less eligible forloans. Consider for example, a firm that has a substantial amountof floating-rate debt, or debt whose interest rate is tied to thecurrent interest rate in the market. If a tightening of monetarypolicy raises interest rates, the firm’s interest costs will rise,reducing its profitability. The firm’s reduced profitability makeslending to the firm riskier (the firm is more likely to gobankrupt), so the firm has trouble obtaining credit. Alternatively,consider a consumer who wants to use some shares of stock that sheowns as collateral for a bank loan. Tighter monetary policy reducesthe value of those shares (as financial investors, lured by higherinterest rates, switch from stocks to bonds). With reducedcollateral, the consumer will be able to borrow less. In eitherexample, the reduction in credit available to the borrower islikely to lead to reduced spending and thus a weaker economy.

What is the evidence for the credit channel? On the supply side ofthe credit market, many economists would argue that the creditchannel was powerful in the United States in the 1960sand 1970s but has been less so recently. The reason for thisweakening is that the deregulation of the banking sector andelimination of reserve requirements for some types of largedeposits have made it easier for banks to maintain their lending,despite a reduction in bank reserves caused by tight money. Forexample, today (unlike twenty years ago), a bank that losesdeposits can replace them by selling certificates of deposit tocorporations or wealthy individuals. A certificates of deposit is alarge fixed-term debt obligation of the bank, against which noreserves need to be held. As the bank doesn’t need to back itscertificates of deposit issuances with reserves, a tightening ofmonetary policy doesn’t affect its ability to raise funds in thisway (except, perhaps, by raising the interest rate that the bankmust pay).

The evidence that monetary policy affects the demand side of thecredit market is stronger. For example, consumer and small firmspending is more sensitive to monetary policy than spending bylarge firms. A likely explanation of this finding is that consumersand small firms are financially riskier than large firms to beginwith, so when monetary policy tightens they are much more likely tofind themselves disqualified for loans. Bankruptcies do increaseamong small firms and consumers following a tightening of monetarypolicy, and small firms and consumers also receive less creditafter monetary policy tightens, relative to that received by largefirms.

Extracted from Macroeconomics (7th Edition) by Andrew B. Abel, BenS. Bernanke, Dean Croushore. Page 551-552.

QUESTION(a) Examine the advantages of credit channel as a monetary policyoption. (b) Discuss the reasons for credit channel to lose its popularityas a monetary policy option. (c) Does tight monetary policy necessarily lead to weaken economicperformance? Clarify your answer. (d) Discuss the mechanism and implications of the policy discussedin (c) on real GDP and prices. Simulate your answer by applying thecause-effect chain diagrams i.e. money/credit market, investmentdemand schedule, AE and AD-AS model.