Channels of Monetary Transmission
Bank Lending Channel
We first examine the role of bank credit. Under a contractionary monetary policy shock ‘bank lending channel’ operates through the fall in bank reserves, implying a reduction in the supply of loan able funds by the banks. In other words, monetary policy may have amplified effects on aggregate demand by modifying the availability or the terms of new loans. The lending channel presumes that small and medium-sized firms, facing informational frictions in financial markets, rely primarily on bank loans for external finance because it is not possible for these borrowers to issue securities in the open market. The importance of this channel thus depends on two factors: (i) the degree to which the central bank has allowed banks to extend loans; (ii) monetary policy stance; and (iii) the dependence of borrowers on bank loans. These factors are clearly influenced by the structure of the financial system and its regulation.
The bank lending channel is an enhancement mechanism to the interest rate channel. The key point here is that the real effects of higher interest rates may be amplified through the lending channel, beyond what would be predicted were policy transmitted only through the traditional interest rate channel (cost of capital). As market interest rates rise subsequent to monetary tightening, business investment falls not only because cost of capital is high but also due to supply of bank loans mostly to small and medium sized firms is reduced.
Exchange Rate Channel
The strength of the exchange rate channel depends on the responsiveness of the exchange rate to monetary shocks, the degree of openness of the economy, and the sensitivity of net exports to exchange rate variations. In a small open economy, a nominal depreciation brought on by monetary easing, combined with sticky prices,results in a depreciation of the real exchange rate in the short-run and thus higher net exports.
Asset Price Channel
The role asset prices may play in the transmission mechanism of monetary policy is well known theoretically, although quite difficult to characterize empirically. Monetary policy shocks results into fluctuations in assets prices. A monetary policy easing can boost equity prices in two ways: (i) by making equity relatively more attractive to bonds (since interest rate fall) and (ii) by improvement in the earnings outlook for firms as a result of more spending by households.
Higher equity prices have dual impact of monetary impulses. First, higher equity prices increase the market value of firms relative to the replacement cost of capital, spurring investment; also, referred to as Tobin’s q theory. Secondly, increase in stock prices translate into higher financial wealth of household and therefore higher consumption.8 In addition, to the extent that higher equity prices raises the net worth of firms and households which improves their access to funds, the effects captured would partly reflect the ‘broad credit channel’ of monetary policy as well.
A broader range of assets, for example real estate – commercial and residential – may be included to cover the wealth effects; however, due to data limitations, we use stock market equity, keeping in mind that these may serve as a proxy to broader range of assets. Typically, peaks in equity prices tend to lead those in real estate prices. However, the relationship is somewhat less clear around troughs.
Direct Interest Rate Channel
The interest rate channel, also referred to as the traditional channel, is the primary mechanism at work in conventional macroeconomic models. Assuming some degree of price stickiness, an increase in nominal interest rates, for example, translates into an increase in the real rate of interest and the user cost of capital. These changes in interest rates may lead to a postponement in consumption or a reduction in investment spending. In the absence of any good indicator for cost of capital, we have measure its impact indirectly.
