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R. Glenn Hubbard is Russell 1. Carson professor of economics and finance at Columbia University. The author is grateful to Allen Berger, Phillip Cogan, Richard Cantor, Mark Gertler, Simon Gilchrist, Anil Kashyop, Don Morgan, Glenn Rudebusch, Bruce Smith and participants at the confer- ence for helpful comments and suggestions. The authar also acknowledges financial support from the Center for the Study of the Economy and the State of the University of Chicaga, and the Federal Reserve Bank of New York.
sidestep the credit view language per se, and Is There a instead focus on isolating particular frictions in financial arrangements and on developing “Credit Channel” testable implications of those frictions, To anticipate that analysis a bit, I argue that for Monetary realistic models of “financial constraints” on firms’ decisions imply potentially significant Policy? effects of monetary policy beyond those working through conventional interest rate channels. Pinpointing the effects of a narrow P. Glenn Hubbard “bank lending” channel of monetary policy is more difficult, though some recent models nderstanding the channels through which and empirical work are potentially promising
/ monetary pohcy affects economic van in that regard. ahies has long been a key research topic I begin by reviewing the assumptions in macroeconomics and a central element of and implications of the money view of the economic policy analysis. At an operational monetary transmission mechanism and by level, a “tightening” of monetary policy by the describing the assumptions and implications Federal Reserveimplies a sale of bonds by the of models of financial constraints on borrow- Fed and an accompanying reduction of bank ers and models of bank-dependent borrow- reserves. One question for debate in academic ers- The balance of the article discusses the and public policy circles in recent years is transition from alternative theoretical models whether this exchange between the central of the transmission mechanism to empirical bank and thebanking system has consequences research, and examines implications for in addition to those for open market interest monetary policy rates. Ac the risk of oversimplifying the debate, the question is often asked as whether the /7/ traditional interest rate or “money view” channel presented in most textbooks is aug- — 7 mented by a “credit view” channel.’ Before discussing predictions for the There has been a great deal of interest in effects of alternative approaches on monetary this question in the past several years, moti- policy, it is useful to review assumptions vated both by developments in economic about intermediaries and borrowers in the models (in the marriage of models of infor- traditional interest rate view of the monetary mational imperfections in corporate finance transmission mechanism. In this view, finan- with traditional macroeconomic models) and cial intermediaries (banks) offer no special recent events (for example, the so-called credit services on the asset side of their balance sheet - ‘For descriptons of the debate, see crunch during the 1990-91 recession),’ As I On the liability side of their balance sheet, Bernanke and Blinder (19f8) and elaborate below, however, it is not always banks perform a special role: The banking Bernanke (1993). straightforward to define a meaningful credit system creates money by issuing demand view alternative to the conventional interest deposits. Underlying assumptions about ‘for on analysis of the ‘credit crnnch’ episode, see Kliesen and rate transmission mechanism. Similar diffi- borrowers is the idea that capital structures Totam (1992) and the studies in culties arise in structuring empirical tests of do not influence real decisions of borrowers the Federal feserne Bank of New credit view models, and lenders, ahe result of Modigliani and York (1994). The paper by Cantar This paper describes and analyzes a broad, Miller (1958). Applying the intuition of the and Rndrigues in the New York Fed though still well-specified. version of a credit Modigliani and Miller theorem to banks, Fama studies considers the possibility of a view alternative to the conventional monetary (1980) reasoned that shifts in the public’s credit cmoch far nonbonk interme- transmission mechanism. in so doing, I portfolio preferences among bank deposits, diaries.
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bonds or stocks should have no effect on real in short-term rates is not obvious a priori Fama’s insight amplifies the endier outcomes; that is, the financial system is based on conventional models of the term contribution of Brainard and Tobin merely a veil.’ structure, Empirical studies, however, have that monetary policy con (1963) To keep the story simple, suppose that documented a significant, positive relationship its effects oe 4 he analyzed through there are two assets—money and bonds, between changes in the (nominal) federal investor portfalias. In a monetary contraction, the central bank funds rate and the 10-year Treasury bond rate Mare fenerolly, in a model with reduces reserves, hmiting the banking system’s (see, for example, Cohen andWenninger, 1993; many assets, this description would ability to sell deposits. Depositors (house- and Escrella and Hardouvelis, 1990). Finally assign to the money view of the holds) must then hold more bonds and less although many components of aggregate effects transmission mechanism on money in their portfolios. If prices do not demand are arguably interest-sensitive (such spending arising fmm any changes instantaneously adjust to changes in the money as consumer durables, housing, business fixed in the relative prices of assets, supply the fall in household money holdings investment, and inventory investment), output While this simple tmoasset-mndel represents adechne in real money balances, To responses to monetary innovations are large description of the money view is highly stylized, it is consistent with restore equilibrium, the real interest rate on relative to the generally small estimated effects a number of alternative models bonds increases, raising the user cost of capital of user costs of capital on investment.’ beyond the texihank IS-IM model for a range of planned investment activities, I shall characterize the money view as (see, for example, Hubbard, 1994), and interest-sensitive spending falls.’ focusing on aggregate, as opposed to distribu- including dynamic-equilibrium cash- While the money view is widely accepted tional, consequences of policy actions. In in-advance madels (far example, as the benchmark or “textbook” model for this view, higher default-risk-free rates of Rotemberg, 1984; and Christiano analyzing effects of monetary policy on eco- interest following a monetary contraction and fichenbaum, 1992). nomic activity, it relies on four key assump- depress desired investment by firms and ‘Far an empidral descripton of this tions: (1) The central bank must control the households. While desired investment falls, transmission mechanism in the con- supply of “outside money,” for which there are the reduction in business and household text of the Federal Reserve’s forecast- imperfect substitutes; (2) the central bank can capital falls on the least productive projects. ing model, see Mauskapf (1990). affect real as well as nominal short-tenn interest Such a view offers no analysis of distribu- 6 See, for example, “limited partici rates (that is, prices do not adjust instanta- tional, or cross-sectional, responses to policy ponien’ models as in Lucas (1990) neously); (3) policy-induced changes in real actions, nor of aggregate implications of this and Chrisfana and lichenbaum short-term interest rates affect longer-term heterogeneity I review these points not to (1992). interest rates that influence household and suggest that standard interest rate approaches See, for example, analyses of business spending decisions; and (4) plausible to the monetary transmission mechanism are incorrect, but to suggest strongly that one innentory irvestnnent ir Kashyap, changes in interest-sensitive spending in Stein and Wilcox (1993) and response to a monetary policy innovation ought to expect that they are incomplete. Gerfer and Gilchist (1993). See match reasonably well with observed output also the review of empirical studies responses to such innovations. HOW REASONABLE IS THE of business fined investment in In this stylized view, monetary policy is Chirinko (1993) and Cammins, represented by a change in the nominal supply CREDIT VIEW? Hassett and Hubbard (1994). of outside money Of course, the quantity The search for a transmission mechanism a This current fashion actually has of much of the monetary base is likely to be broader than that just described reflects two long pedigree in macroecenemics, endogenous.° Nonetheless, legal restrictions concerns, one “macro” and one “micro,” The with iniporlont cantrihutions by Fisher (for example, reserve requirements) may macro concern, mentioned earlier, is that (1933), Gudey and Show (1955, compel agents to use the outside asset for cyclical movements in aggregate demand— 960), Minsky (1964, 19/5) and some transactions, In practice, the central particularly business fixed investment and Walnilawer 11980), Some econa- bank’s influence over nominal short-ternn inventory investment—appear too large to metric ferecosfing medels have also interest rates (for example, the federal funds be explained by monetary policy actions that focosed on financial factors in prop- rate in the United States) is uncontroversial, have not generally led to large changes in agafon mechaaisms (see, for There is also evidence that the real federal real interest rates, This has pushed some example, the description for the DRI funds rate responds to a shif’t in policy (see, macroeconomists to identify financial factors model in Eckstein and Sinai, 19861. for example, Bernanke and Blinder, 1992). in propagating relatively small shocks, fac- Cogan (19/2) provides an ernpiicol bank lending Turning to the other assumptions, tors that correspond to accelerator models analysis of money and 0 views. Mr early contributor tu the that long-term rates used in many saving that explain investment data relatively well, contemporary credit view literature and investment decisions should increase or Indeed, I use the term “financial accelerator” is Bemanke (1983). decrease predictably in response to a change (put forth by Bernanke, Gender and Gilchrist,
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forthcoming) to refer to the magnification of a gapbetween the cost of external and internal initial shocks by financial market conditions, finance for many borrowers, In this context, The micro concern relates to the emer- the credit view offers channels through which gence of a growing literature studying infor- monetary policy (open market operations or mational imperfections in insurance and credit regulatory actions) can affect this gap. That markers. In this line of inquiry problems of is, the credit view encompasses distributional selec- asynimetric information between borrowers consequences of policy actions, because the Potential effects of advene and lenders lead to agap between the cost costs of finance respond differently for different tion problems on market allocation of external finance and internal finance. types of borrowers. Two such channels have have been addressed in important The notion of costly external finance stands been discussed in earlier work: (1) financial papers by Akedof (1970) and Rothschild and Stglitz (1976), and in contrast to the more complete-markets constraints on borrowers and (2) the exis- been applied to moo markets approach underlying the conventional interest tence of bank-dependent borrowers, have by laffee and Russell (1976) and rate channels, which does not consider hnks Stiglitz and Weiss (1981), and to between real and financial decisions,r equity markets by Myers and Although a review of this literature is Wailaf (1984). Research an piaci beyond the scope of this article, I want to Any story describing a credit channel for pal-agent problems in finance has mention three common empirical implica- monetary policy must have as its foundation followed the contribotion of larson tions that have emerged from models of the the idea that some borrowers face high costs and Meckling (1976). Gertler 0 financial accelerator’ The first, which Ijust of external finance, In addition, models of 11988), Bernanke (1993) and noted, is that uncollaceralized external finance a financial accelerator argue that the spread King and Lenine (1993) pmvide reviews of related models of infor- is more expensive than internal finance, between the cost of external and internal funds Second, thespread between the cost of external varies inversely with the borrowers’ net worth, mational imperfectiens in capital markets. and internal finance varies inversely with the It is this role of net worth which offers a borrower’s net worth—internal funds and channel through which policy-induced “See also the review in Bernanke, collateralizable resources—relative to the changes in interest rates affect borrowers’ Gender and Gilchrist (forthcoming). amount of funds required. Third, an adverse net worth (see, for example, Gertler and These implications ore consistent shock to a borrower’s net worth increases the Hubbard, 1988). Intuitively increases in the with a wide class of models, in rInd- ing those of Townsend (1979), cost of external finance and decreases the real interest rate in response to a monetary Blinder and Stiglitz (1983), ability of the borrower to implement invest- contraction increase borrowers’ debt-service Farmer (1985), Williamsen ment, employment and production plans. burdens and reduce the present value of (1987), Bereunke and Gender This channel provides the financial accelerator, collateralizable net worth, thereby increasing (1989, 1990), Calominis and magnifying an initial shock to net worth, the marginal cost of external finance and Hubbard (1990), Sharpe (19901, (See, for example: Fazzari, Hubbard and reducing firms’ ability to carry out desired Hart and Meow (19911, Kiyotaki Petersen, 1988; Gertler and Hubbard, 1988; investment and employment programs, This and Moore (1993), Gender Cantor, 1990; Hoshi, Kashyap and Scharfstein, approach offers a credit channel even if open (1992), Greerwald and Stiglitz 1991; Calomiris and Hubbard, forthcoming; market operations have mo direct quantity (1988, 19931 and Iomoat(1993). Hubbard and Kashyap, 1992; Oliner and effect on banks’ ability to lend, Moreover, ‘‘Far households, Mishkin 119/7, Rudebusch, 1992; Fazzari and Petersen, 1993; this approach implies that spending by low- 1978) and Leldes (19891 pmnide Hubbard, Kashyap and Whited, forthcoming; net-worth firms is likely to fall significantly evidence of effects of hausehold Bond and Meghir, 1994; Cummins, Hassett following a monetary contraction (to the balance sheet conditions on con- and Hubbard, 1994; Carpenter, Fazzari and extent that the contraction reduces borrowers’ sumer enpenditures. Petersen, 1994; and Sharpe, 1994.)” Links net worth). The appendin presents a simple between internal net worth and broadly defined model that illustrates these predic- investment (holding investment opportunities tions. constant) have been corroborated in a number t~5~.flceOt H~cyncc4f’pndànrt “For broader desciptiens of credit of empirical studies.rr view arguments, see Bemanke Let me now extend this argument to The second channel stresses that some (1993), friedman and Kottner include a channel for monetary policy” In borrowers depend upon banks for external (1993), Gender (1993), Gerfer the money vie~policy actions affect the funds, and that policy actions can have a direct and Gilchrist (1993) and Kashyap overall level of real interest rates and inter- impact on the supply of loans. When banks and Stein (1994). An early eupo- est-sensitive spending. The crux of models are subject to reserverequirements on liabihties, sition of a role for cmditavailability of information-related financial frictions is a monetary contraction drains reserves, appears in fooso (1951).
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possibly decreasing banks’ ability to lend. As exogenous changes in banks’ ability to lend. a result, credit allocated to bank-dependent Four such changes have been examined in borrowers may fall, causing these borrowers previous research. The first focuses on the to curtail their spending. In the IS-LM role played by banking panics, in which framework of Bernanke and Blinder (1988), depositors’ flight to quality—converting hank both the IS and LM curves shift to the left in deposits to currency or government debt— response to a monetary contraction, Alterna- reduces banks’ ability to lend (for empirical tively an adverse shock to banks’ capital could evidence, see Bernanke, 1983, and Bernanke decrease both banks’ lending and thespending andJames, 1991, for the 1930s and Calomiris “Models of equlibrium credit by bank-dependent borrowers. Such bank and Hubbard, 1989, for the National Banking rationing onder adverse selection lending channels magnify the decline in out- period). (for enample, Stiglitz and Weiss, put as a result of the monetary contraction, A second argument emphasizes regulatory 1981) offer another mechanism through which on increase in the and the effect of the contraction on the real actions, such as that under binding Regulation level of defanlt-risk-free real interest interest rate is muted. This basic story raises Q ceilings in the United States (see, for mtes reduces loon sapply. Credit three questions, relating to: (1) why certain example, Schreft, 1990; Kashyap and Stein, rationing is rot reqaired for the borrowers may be bank-dependent (that is, 1994; and Romer and Romer, 1993) and reg- bonk-dependent-barrower channel unable to accessopen market credit or borrow ulation of capital adequacy (see, for example, no be operative. Insteod, what is from nonbank financial intermediaries or Bernanke and Lown, 1992; and Peek and required is that loans tu these bor- other sources), (2) whether exogenous changes Rosengren, l ).,~Empirical evidence for 992 rawers are an imperfect substitute in banks’ ability to lend can be identified, and this channel is quite strong. Third, Bizer for other assets and that tine bar- (3) (for the analysis of open market operations) (1993) suggests that increased regulatory roman lack alternative sources of whether banks have access to sources of funds scrutiny decreased banks’ willingness to finance. not subject to reserve requirements. lend in the early 1990s, all else equal.
° Colomiris and Kahn (1991) offer The first question is addressed, though The fourth argument stresses exogenous model of demandable debt tu not necessarily resolved, by the theoretical changes in bank reserves as a result of shifts haooce bank lending. literature on the development of financial in monetary policy In principle, such a shift ‘‘A substantial body of empitical evi intermediaries”, In much of this research in monetary policy could be identified with a dence sopports the idea that banks (see especially Diamond, 1984; and Boyd discrete change in the federal funds rate in the offer special services in the lending and Prescott, 1986), intermediaries offer aftermath of a dynamic open market operation process. For example, James low-cost means of monitoring some classes or with achange in reserve requirements. (19871 and lummer and of borrowers. Because of informational fric- Because the effects on reserves of changes in McCaneell (1989) find that the tions, non-monitored finance entails dead- reserve requirements are generally offset by announcement of a bank loon, oil weight spending resources on monitoring. A open market operations, bank-lending-chan- the ptice of else equal, mises share free-rider problem emerges, however, in pub- nel stories are generally cast in terms of open the barmwing firm, likely reflecting lic markets with a large number of creditors. market operations. the information content ol the The problem is mitigated by having a finan- An illustration of the gap between models bank’s assessment, In a similar spirit, loma (1985) and James cial intermediary hold the loans and act as a and practice surfaces in addressing the third (1987) find Chat honks’ borramers, delegated monitor, Potential agency problems question of the ease with which banks can raise rather than banks’ depositors, bear at the intermediary level are reduced by having funds from non-deposit sources (for example, the incidence ol reserve reqaire- the intermediary hold a diversified loan port- CDs), when the Fed decreases reserves. Romer ments (indicating that borrowers folio financed principally by publicly issued and Romer (1990) have pointed out, for mast not hove easy access tu other debt.” This line of research argues rigorously example, that if banks see deposits and CDs sources of funds). Petersen and that borrowers for whom monitoring costs as perfect substitutes, the link between open (1994) Ralan show that small are significant will be dependent upon inter- market operations and the supply of credit to businesses tend to rely on lacal mediaries for external finance,” and that costs bank-dependent borrowers is broken. Banks hanks for enternal funds. of switching lenders will be high.” It does not, are unlikely however, to face a perfectly elastic ‘‘See, far euomple, the discussion in however, necessarily argue for bank dependence supply schedule for CDs at the prevailing CD Petersen and Roman mi 994). (for example, finance companies are interme- interest rate, Since large-denomination CDs re Omens and Schreft (1992) discuss diaries financed by non-deposit debt). are not insured at the margin by federal deposit the ident’dication of ‘credit crunch- Second, even if one accepts the premise insurance, prospective lenders must ascertain es.’ See also the description in that some borrowers are bank-dependent in the quality of the issuing bank’s portfolio. Hubbard 11994), the sense described earlier, one must identify Given banks’ private information about at
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least a portion of their loan portfolio, adverse banks or other financial intermediaries) facing selection problems will increase the marginal incomplete financial markets, Examining cost of external finance as more funds are links between the volume of credit and eco- raised (see, for example, Myers and Majluf, nomic activity in aggregate data (with an eye 1984; and Lucas and McDonald, 1991). In toward studying the role played by bank- addition, as long as some banks face constraints dependent borrowers) requires great care. on issuing CDs and those banks lead to Simply finding that credit measures lead output bank-dependent borrowers, a bank lending in aggregate time-series data is also consistent channel will be operative. with a class of models in which credit is passive, While the foregoing discussion centers responding to finance expected future output on open market operations, regulatory actions (as in King and Plosser, 1984), Consider the by the central bank—credit controls, for case of a monetary contraction, for example. example—represent another way in which The effect of the contraction on interest rates monetary policy can have real effects through could depress desired consutnption and influencing the spending decisions of bank- investment spending, reducing the demand dependent borrowers. Here the effects are for loans. likely to be more pronounced than for the In a clever paper that has stimulated a case of open market operations, since the number of empirical studies, Kashyap, Stein question of the cost of non-deposit sources and Wilcox (1993)—henceforth, KSW— of funds is no longer central, and the effec- examine relative fluctuations in the volume tiveness of such regulatory actions depends of bank loans and a close open market sub- only on the existence of bank-dependent stitute, issuance of commercial paper. In the borrowers. KSW experiment, upward or downward shifts in both bank lending and commercial flQffsfl~ly~tsnCrr?it°.MOLWLC TQ paper issuance likely reflect changes in the demand for credit, However, a fall in bank ‘2 ‘2’2inø°i’24 srts’2i,.fd’2c2,22 °2~2er lending while commercial paper issuance is Both the financial-constraints-on-bor- rising might suggest that bank loan supply is rowers and bank-lending-channel mechanisms contracting. To consider this potential co- imply significant cross-sectional differences movement, KSW focus on changes over time in firms’ shadow cost of finance and in the in the mix between bank loans and commer- response of that cost to policy-induced changes cial paper (defined as bank loans divided by in interest rates. Accordingly empirical the sum of bank loans and commercial paper). researchers have attempted to test these They find that, in response to increases in cross-sectional implications. As I examine the federal funds rate (or, less continuously this literature, I explore how Modigliani-Miller at the times of the contractionary policy violations for nonfinancial borrowers, financial shifts identified by Romer and Romer, 1989). Oliner and fadebasch (1993) and intermediaries or both offer channels for the volume of commercial paper issues rises, (1993) monetary policy beyond effects on interest while bank loans gradually decline, They Friedman and Kattaner hone disputed the KSW interpretation of rates. The appendix frames this discussion also find that policy-induced changes in the the mia as measadag a substitution using a simple model; an intuitive presenta- mix have independent predictive power for between bank loans and commer- inventory and fixed investment, holding con- tion follows. cial paper. They argue than, during stant other determinants.” recession, shifts in the miu are The aggregate story told by KSW masks erplained by an increase in con EMPIIU.CAL !flSEARt*I, oN significant firm-level heterogeneity however. merciol paper issuance rather than THE CREDIT VIEW The burden of a decline in bank loans fol- by a decrease in bank loans, Studies Using Aqqregote Da.tu lowing a monetary contraction is borne by “Morgan (1993) finds a similar smaller firms (see Gertler and Gilchrist, 1994).” result in en 000lysis of loan corn- The microeconomic underpinnings of Moreover, the evidence in Oliner and mitments, After an episode of both financial accelerator models and the Rudebusch (1993) indicates that once trade monetary contraction, firms withont credit view of monetary policy hinge on credit is incorporated in the definition of loan commitments receive a small- certain groups of borrowers (perhaps including small firms’ debt and once firm size is held er share of bank loans.
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constant, monetary policy changes do not two-year period following a monetary tight- alter the mix. ening, results consistent with the financial It also does not appear that hank-depen- accelerator approach. They also demonstrate dent borrowers switch to the commercial that the effects of shifts in monetary policy paper market following a monetary contrac- on the small-firm variables are sharper in tion. Instead, the increase in commercial periods when the small-firm sector as a whole paper issuance reflects borrowing by large is growing more slowly also consistent with firms with easy access to the commercial the financial accelerator approach. Finally paper market, possibly to smooth fluctua- they show that the ratio of cash flow to interest tions in their flow of funds when earnings expense (a measure of debt-service capacity) decline (Friedman and Kuctner, 1993) or to is associated positively with inventory accu- finance loans to smaller firms (Calomiris, mulation for small, but not for large, manu- Himmelherg and Wachtel, forthcoming). facturing firms. The Gertler and Gilchrist results, which are very much in the spirit of the earlier cross—sectional tests of financial accelerator models, have been borne out for studies of 1’ Toward this end, more direct com- More convincing empirical tests focus fixed investment by Oliner and Rudebusch parisons of borrowing by bark- on the cross-sectional implication of the (1994) and for inventory investment by dependent and nonboak.dependent underlying theories—namely that credit- Kashyap, Lamont and Stein (1994),” In addi- barrowers hove been offered. market imperfections affect investment, tion, Ramey (1993) shows that, for forecast- Using firm-lenel data, Kashyop, employment or production decisions of some ing purposes, the ratio of the sales growth of end Steir (1994)— tamont borrowers more than others. At one level, small firms to that for large firms offers sig- henceforth KLS—follow the existing cross-sectional empirical studies have nificant information about future GDP. Fozzari, Hubbarri and Petersen been successful: There is asubstantial body Finally using the firm-level data 11988) approach of classifying groups of firms as a priori finance- of empirical evidencedocumenting that proxies underlying the aggregates summarized in constrained hr this case, bank- for borrowers’ net worth affect investment the Quarterly Financial Reports, Bernanke, dependent) or not. Ir particular, more for low-nec-worth borrowers than for Gertler and Gilchrisc (forthcoming) analyze they stody inventory investment by high-net-worth borrowers (holding constant the differences in sales and inventories between peblicly traded firms mitlr and with- invesnnent opportunities). This suggests large and small manufacturing firms by out bond rotirgs, as a prony for that, to the extent that monetary policy can two-digit industry They find that fluctua- bank dependence. focusing on the affect borrowers’ net worth, pure interest tions in the large firm-small firm differences 1982 recession (as an indirect rate effects of open market operations will areroughly the same size as fluctuations in wears of identifying a period fol- be magnified. the corresponding aggregate fluctuations for lowing a tight money episode), The second body of empirical analysis of the manufacturing sector. Because small firms’ they find that inventury innestnent information-related imperfections focuses on sales (as they define small firms) comprise by nan-rated firms was influenced, all else equal, by the firms’ own the effects of monetary policy on borrowers’ about one-third of the sales of the manufac- cash holdings, on effect not present balance sheets. Gercler and Hubbard (8988) turing sector, roughly one-third of cyclical for the innertory investment by conclude that, all else equal. internal funds fluctuations in manufacturing sales can be rated firms, tn subsequent boom have a greater effect on investment by non- explained by large firm-small firm differences, years (which KLS identify with on dividend-paying firms during recessions. easy money episode), they lied lit- The evidence of Gertler and Gilchrist (1994) in effect of cash holdings on inven- is particularly compelling here. Analyzing M.S’MSSSIflST ‘2220. Durtk t.uncnnq tory investment for either non-roted the behavior of manufacturing firms summa- or rated companies. These patterns rized in the Quarterly Financial Reports data, While the principal empirical predictions lead KtS to conclude that a bank Gertler and Gilchrist consider differences in of the financial accelerator approach have been lending channel was operative in small and large firms’ responses to tight corroborated in micro-data studies and low- response to the monetary contrac- nec-worth firms appear to respond differen- tion. Hawener, the KLS resolts are money (as measured by federal funds rate consistent with a more general innovations or the dates identified by Romer tially to monetary contractions, the question model in which low-nat-worth firms and Romer, 1989). In particular, small firms’ of the role of banks remains. I consider this foce more costly erternalfinance in sales, inventories and short-term debt question below in three steps. downtnrns. decline relative to those for large firms over a First, is there evidence of significant
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departures from Modigliani and Miller’s emerges when loans are disaggregated to results for certain groups of banks in the include just commercial and industrial loans. sense that have been identified for firms? One possible explanation for the Kashyap Second, is there evidence that small- or low- and Stein pattern is that a monetary contrac- net-worth firms are more likely to he the tion weakens the balance sheet positions of loan customers of such banks? Finally do small firms relative to large firms. If small low-net-worth firms have limited opportuni- firms tend to be the customers of small banks ties to substitute credit from unconstrained and large firms tend to be the custoaners of financial institutions when cut off by con- large banks, a fall in loan demand (by small strained financial institutions? borrowers) for small banks could be consis- tent with the differential lending responses noted by Kashyap and Stein, To examine
0 this possibility Kashyap and Stein analyze whether small banks increase their holdings Kashyap and Stein (1994) apply the of securities relative to large banks during a intuition of the models of effects of internal monetary contraction, They actually find net worth on investment decisions by nonfi- chat small banks’ securities holdings are less nancial firms to study financing and lending sensitive to monetary policy than large banks’ decisions by banks. This is an important securities holdings, though the difference in line of inquiry in the hank lending channel the responses is not statistically significant. research agenda, because ft addresses the ease The use of hank size as a measure to gen- with which banks can alter their financing erate cross-sectional differences does not corre- mix in response to a change in bank reserves spond precisely to the underlying theoretical and the effect of changes in the financing models, which stress the importance of net mix on the volume of bank lending. Just as worth. In this context, bank capital may he earlier studies focused on cross-sectional dif- a better proxy Peek and Rosengren (forth- ferences in financing and real decisions of coming) analyze the lending behavior of New nonfinancial firms of different size, Kashyap England banks over the 1990-9 1 recession. and Stein analyze cross-sectional differences Their results indicate that the loans of well in financing and lending decisions of banks capitalized banks fell by less than the loans of different size. To do this, they use data of poorly capitalized banks.” Hence, as with drawn from the quarterly “Call Reports” the Kashyap and Stein findings, their evidence collected by the Federal Reserve, suggests there are effects of infonnational Kashyap and Stein construct asset size imperfections in financial markets on the groupings for large banks (those in the 99th balance sheets of intermediaries as well percentile) and small banks (defined as those as horrowers. “Using dotu on commercial banks at or below the 75th, 90th, 95th or 98th natonwrle onerthe 1979-92 period, percentiles). They first show that contrac- Berger and Udell 119941 bond lit- tionary monetary policy (nneasured by an tanrnvnu ti~rrcJvePt-cnr,d ~ tle enidence that the introduction of tisk-irased capitul requirements per Se increase in the federal funds rate) leads to The last Iwo questions relate to the affected credit ollocotior. Hancock, a similar reduction in the growth rate of nom- matching of borrowers and lenders. The Laing and Wilcan 119941 also rse inal core deposits for all hank size classes. former asks whether the firms identified by qvortedy data on iudividuul honk’s They find significant heterogeneity across empirical researchers as finance-constrained portfolios to estimate the respan- hank size classes, however, in the response are the loan customers of the constrained sireress of portfolio composition to of the voluene of lending to a change in mon- (small) banks such as those identified by changes in capitol requirements. etary policy In particular, a monetary corn- Kashyap and Stein. This line of inquiry They find that ‘copitul shortfall’ traction leads to an increase in lending in requires an examination of data on individ- institutions reduced their Cal loors t.he short run by very large banks. This is in ual loan transactions, with information on response by larger total amounts, contrast to a decline in lending in the short characteristics of the borrower, lender and all else equal, titer ‘copitol surplus’ run by smaller banks. These do not simply lending terms.” One could establish whether institutions. reflect differences in the type of loans made constrained firms are the customers of con- ‘2 Aril Koshyop, Darius Polio and lore by large and small banks. A sinnilar pattern strained banks and whether such firms cunertfy ergoged ir such an anolyis.
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switch from constrained banks to uncon- ponents of outside money over which the strained ones during episodes of monetary central bank can exercise exogenous control. contractions. Theories emphasizing the impor- First identifying exogenous changes in mone- 5 tance of ongoing borrower-lender relationships tamy policy is difficult.’ Recent research by imply that such switches are costly and unhkely Bernanke and Blinder (1992) and Christiano, If true, part of themonetary transmission Eichenbaum and Evans (forthcoming) offers mechanism takes place through reductions promising strategies for studying the effects in loan supply by constrained banks. of monetary policy shocks. The latter of the two questions suggests In addition, recent analyses of policy- the need to study a broader class of lenders reduced-form models document a significant, than banks, Ifborrowers from constrained negative relationship in quarterly data between banks can switch at low cost to nonbank the percentage change in real GDP relative to ‘2 Another possibil’ty is that the lenders following a monetary contraction, potential GDP and the change in the federal weakened balance sheet positions the narrow bank credit channel of monetary funds rate.mu Such studies must first confront of many borrowers precipitutes policy is frustrated. In this vein, Calomiris, the possibility that the measured interest o ‘flightto quality’ by lenders Flimmelberg and Wachtel (forthcoming) ana- sensitivity of output reflects links between generally, increasing the demand lyze finn-level data on commercial paper for commercial paper issues of interest race and net worth changes for certain groups of borrowers/spenders. A second large firms, issuance and argue that large, high-quality 5 commercial paper-issuing flrnms increase issue, noted by Morgan (1993) and Cohen ‘ The dates of monetary policy paper borrowings during downturns to and Wenninger (1993), is that quarterly contractions saggested by Rower finance loans to smaller firms.’2 They note residuals from estimated policy-reduced-form and Rawer (19891 have generated that accounts receivable rise for paper-issu- equations display large negative errors during significant controversy. Shapiro (1994) argues, for erawple, ing firms, supporting the notion chat these recessions, suggesting the possibility of an that empirical evidencefarors the firms may serve as trade credit intermedi- asymmetric response of economic activity to hypothesis thnt several Rower dates aries for smaller firms in some periods. increases or decreases in the federal funds are predictable asing weaseres From the standpoint of the bank lending ~ Finally more theoretical and empirical of unemployment and infanion channel, it is important to establish what research is needed to examine links between as deterninants of actions by the happens to the costs and terms imposed by changes in short-term real interest rates (which Federal Open Market Committee; these intermediaries. If, on the one hand, are significantly influenced by pohcy actions) see also the discussion in Cecchett such terms are no more costly than bank and changes in long-term real interest races (1995). Hoover and Perez (1994) intermediary finance, then the switch of bor- (which affect firms’ cost of capital). offer a number of criticisms of the rowers from being bank customers to being lowers’ appraach. trade credit customers entails very limited fl~-r~~ryq Intlsi:fl ii1yiyiifliui,, ‘°Such relationships are lypically macroeconomic effects. On the other hand, ,t’aW’tt0ns”*~nC’ i.anns 222222 estimated as: if large, paper-issuing firms accept their ~ .~22o - Yht)”a+ bY(.t— il intermediary role reluctantly very costly RgMJrtY trade credit may exacerbate a downturn This survey argues that the terms money — cH(t— il—dEbt—i), by raising the cost of funds for constrained view and credit view are not alwayswell- where is the percentage change Y firms. More empirical investigation of defined in theoretical and empirical debates in real GOP miatine to potential trade credit terms is needed to resolve over the transmission mechanism of mone- GOP, His the percentuge chatge in this question. the high-employmentfederal bad- tary policy Recent models of information get surplus, F is the change in the and incentive problems in financial markets federol funds rate, tis the currerot suggest the usefulness of decomposing the time period, and idenotus lags. transmission mechanism into two parts: one See, for enample, Hirtle and Kelleher related to effects of policy-induced changes (1990), Pen-y and Schultze (1992) More empirical research is also needed on the overall level of real costs of funds; and and Cohen and Wenninger (19931. to assess the validity of the basic money one related to magnification (or financial “Cover (1992) finds still stronger view A central problem is that, while most accelerator effects) stemming from impacts evidence of asymmetric effects empirical studies focus on monetary aggre- of policy actions on the financial positions of when monetary aggregates are gates such as M2, the theoretical description borrowers and/or intermediaries. used as the policy indicator instead offered in the first section suggests an emphasis Two observations emerge clearly from of the federal funds rnte, on outside money and, importantly on com- the literature, First, the spending decisions
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of a significant group of borrowers are influ- Berger, Allen N., and Gregory F. Udell. ‘Did Risk-Based Capital Allocate enced by their balance sheet condition in the Bank Credit and Cause a ‘Credit Crunch’ in the U.S.?” (port two) ways described by financial accelerator models. Journal at Money, Credit and Banking (August 1994), pp. 585-628. Second, even in the presence of more sophis- Bernanke, Ben S. ‘Credit in the Macroecanatny,” Federal Reserve Bank ticated financial arrangements, there are still of New York Quarterly Review (spring 1993), pp. 50-70, information costs of screening, evaluation ______‘Nonmonetary Effects of the Financial Crisis in the and monitoring in the credit process, impart- Propagation of the Great Depression,” The American Economic Review ing a special role for intermediaries (be they (June 1983), pp. 257-76. banks or other lenders) with cost advantages ______Federal Funds Rate and the in performing these tasks.’° and Alan S. Blinder. ‘The Channels of Monetary Transmission,’ The American Economic Review The first observation suggests that (September 1992), pp. 901-21. financial factors are likely to continue to play a role in business fluctuations. The second ______and ______- ‘Crecit, Money, and Aggregate suggests that regulatory policies affecting Demand,” The American Economic Review (May 1988), pp. 435-39. information-specializing intermediaries are ______and Mark Gerfier. “Agency Cost, Net Worth, and Business likely to affect the cost of credit for at least Fluctuations,” The American Economk Review (March 1989), pp. 14-31. some borrowers, In part because of interest ______and ______. “Financial Fmgility and Economic in alternative views of the monetary trans- Performance,” Quarterly Journal atEconomics (February 1990), mission mechanism and in part because of pp.87-il4. concern over the effects of institutional change in the financial system, academics and poli- ______and Simon Gilchrist. “The Financial and the Flight to Quality,” cymakers are analyzing whether the scope Accelerator Review of Economics and Statistics (forthcoming). for monetary policy to affect real outcomes is becoming narrower. Both observations ______and Harold James. ‘The Gold Standard, Deflation, and noted above are consistent with a heightened Financial Crisis in the Great Depression: An International Comparison,” role for monetary policy in affecting real in R. Glenn Hubbard, ed., Financial Markets and Financial Crises. decisions of firms with weak balance sheet University of Chicago Press, 1991.
positions. Developing ways to incorporate ______and Cara S. lawn, ‘The Credit Crunch.” Braakings Papers borrower heterogeneity in both economic an EcanamicActivity(1992:2), pp. 205-39. models of money and credit and in forecasting Bizer, Dovid S. ‘Regulatory Discretion and the Credit Cwnch,” working is an important, practical task for economic paper (April 1993), U.S. Securities and Exchange Commission. modelers and policymakers. Whether the simplest bank lending Blinder, Alan S., and Joseph F. Stiglitz. ‘Money, Credit Constraints, and Economic Activity,” TheAmerican Economic Review (May 1983), pp. channel—that a fall in banks’ reserves fol- 297-302. lowing contractionary open market operations decreases both banks’ ability to lend and bor- Bond, Stephen, and Castos Meghir. ‘Dynamic Investment Models and rowers’ ability to spend—is operative is not the Firm’s Financial Policy,” Review of Econamk Studies (April 1994), clear, however, More micro-evidence at the pp. 197-222. level of individual borrower-lender transac- Boyd, John H., and Mark Gertler, “Are Banks Dead? Or, Are the Reports tions is needed to resolve this question. At Greatly Exaggerated?’ working paper (Moy 1994), Fedeml Reserve the same time, proponents of the simplest Bank of Minneapolis. characterization of an interest rate channel ______and Edward Prescott. ‘Financial lntermediory-Coalitions,’ must address both the cross-sectional hetero- Journal of Economic Theory (April 1986), pp. 211-32. geneity in firms’ response to monetary policy ______and Bruce D. Smith. “Capitul Market Imperfections in a and the extent to which observed interest rate Monetury Gmwth Model,” Working Paper Na. 533 (August 1994), effects on output reflect differentially large Federal Reserve Bank of Minneapolis. on For recent analyses of the future of effects of policy on certain classes of borrowers, banking, see Gortan and Pennacchi Brainord, William C., and James Tabin. ‘Financial Intermediaries and and the Effectiveness of Monetary Controls,’ The American Economic (1993), Edwards (1993) Review (May 1963), pp. 383-400. Boyd and Gertler (1994). Akerlob, George. ‘The Market for lemons: Quality Uncertuinty ond the Thornton (1994) discusses likely Market Mechanism,” Quarterly Journal of Economics (August 1970), Cagan, Phillip. The Channels of Monetary Effects an Interest Rates. effects of recent financial innova- pp. 488-500. Columbia University Press, 1972. tions on the bank lending chunnel,
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Calomiris, Charles W., Charles P Himmelberg and Paul Wachtul. Eckstein, Otto, and Allen Sinai, “The Mechanisms of the Business Cycle ‘Commercial Paper and Corparote Finance: A Microeconamic in the Postwar Era,” in Robert J. Gordon, ed., The American Business Perspective,” Carnegie-Rochester Conference Series on Public Policy Cyde: Continuity and Change. University of Chicago Pmss, 1986.
(farthcomtng) - Edwards, Franklin R. ‘Financial Markets in Transitiorn—Or the Decline
______and R. Glenn Hubbard. ‘Firm Heterogeneity, Inturnol of Commercial Banking,” in Changing Capital Markets: Implications for Finance, and ‘Credit Ratianing,’” Economic Journal (March 1990), Monetary Policy. Federal Reserve Bank of Kansas City, 1993. ~ 90-1 04. Estrella, Arturn, and Gikas Hordouvelis. “Possible Roles of the Yield
______and ______. ‘Price Flexibility, Credit Availability, and Curve in Monetory Policy,” in Intermediate Targets and Indicators of Economic Fluctuations: Evidence from the United States, 1894-1909,’ Monetary Policy: A Critical Survey, 1990, Federal Reserve Bank of Quarterly Journal of Economics (Angnst 1989), pp. 429-52. New York, 1990, pp. 339-62.
______and ______. ‘Tax Policy, Internal Finance, and Fama, Eugene F. “Banking in the Theory of Finance,” Journal of Investment: Enidence from the Undistributed Profits Tax of 1936-37,” Monetary Economics (January 1980), pp. 39-57. Journal of Business (forthcoming). Fama, Eugene F. “What’s Different About Banks?’ Journal of Monetary
______and Charles Kahn. ‘The Role af Demandable Debt in Economics (June 1985), pp. 29-39. Structuring Optimal Banking Arrangements,” TheAmerican Economic Farmer Roger E.A. “Implicit Contracts with Asymmetric Information and Review (June1991), pp. 497-513. Bankruptcy: The Effect of Interest Rates an Layoffs,” Review of Cantor, Richard. “Effects of levemge on Corporate Intestment and Economic Studies (July 1985), pp. 427-42, Hiring Decisions.” Federal Reserve Bank of New Ynrk Quortedy Fozzoti, Steven M., and Bruce C. Petersen. ‘Working Capital and Fixed Review (summer 1990), pp. 3141. Investment: New Evidence on Financing Constraints,’ RAND Journal
______and Anthony P. Rodrigues. ‘Nonbank lenders and of Economics (ontnmn 1993), pp. 328-42. the Credit Slowdown,’ in Studies on Causes and Consequences Fazzari Steven M., R. Glenn Hubbard, and Bruce C. Petersen. of the 1984-1992 Credit Slowdown. Fedeml Reserve Bank of “Financing Constroints and Corpomte Investment.” Brookings Papers New York, 1994, on Economic Activity (1988:1), pp. 141-95, Carpenter, Robert, Steven M. Fazzori and Bruce C. Petersen. ‘Inventory Federol Reserve Bank of New York. Studies on Causes and (Dis)investment, Internal Finance Fluctuations, and the Business Consequences ofthe 1989-1992 Credit Slowdown, Febmary 1994. Cycle,” Bmokings Papers on Economic Activity (1994:2). Fisher, Irving. ‘The Debt-Deflation Theory of Great Depressrons.” Cecchetti, Stephen G. ‘Distinguishing Theories of the Monetory Econometrica / (Octuber 1933), pp. 337-57. Transmission Mechanism,” this Review (May/June 1995), . nn 83-100 Frtedman, Benlamtn M., and Kenneth N. Kuttner, Economtc Actnvnty and the ShortTerm Credit Markets: An Analysis of Prices and Quantities,” Chirinko, Robert S. ‘Business Fixed Investment Spending: A Critical Survey,” Brookings Papers an Economic Activity (1993:2), pp. 193-266. Journal of Economic Literature (December 1993), pp. 1875-911. Gertler, Mark. Comment on Chrrstina 0. Romer and Dannd H. Romer, Christiono, lawrence, and Martin S. Eichenboam. ‘liquidity Effects and ‘Credit Channel or Credit Actions?: An Interpretation of the Postwar the Monetary Transmission Mechanism,’ The American Economic Transmission Mechanism,” in Chonging Capital Markets: Implications Review (May 1992), pp. 34653. for Monetary Policy. Federal Reserve Bank of Kansas City, 1993.
______and Charles Evans. ‘The Effects of Monetary ______. ‘Financial Capacity and Output Fluctuations in an Policy Shocks: Evidence from the Flow of Funds,” Review of Economy with Multi-period Financial Relationships,” Review of Economics and Statistics (forthcoming). Economic Studies (1992), pp. 455-72,
Cohen, Gerald, and John Wenninger. ‘The Relationship Between the ______, ‘Financial Structure and Aggregate Economic Activity: An Federal Funds Rate and Economic Activity,” working paper (December Overview,’ Journal of Money, Credit and Banking (August 1988, part 2), 1993), Federal Reserve Bank of New York. pp. 559-88.
Cover, John Pery. “Asymmetric Effects of Positive and Negative Money ______and Simon Gilchrist, “Monetary Policy, Business Cycles, and Stpply Shocks,” Quarterly Journal of Economics (November 1992), the Behavior of Small Manufacturing Firms,” Quarterly Journal of pp. 1261-82. Economics (May 1994), pp. 309-40,
Cummins, Jason G., Kevin A, Hasseti and R. Glenn Hubbard. ‘A ______and ______. ‘The Role of Credit Market Imperfections Reconsideration of Investment Behavior Using Tax Reforms as Natural in the Monetary Transmission Mechanism: Arguments and Evidence,” Experiments,” Srookings Papers on EconomicActivity (1994:2), Scondinavian Journal of Economics (No. 1, 1993), pp. 43-64. 1~174, Gertler, Mark, and R. Glenn Hubbard. “Corporate Financial Policy, Diamond, Douglas W. “Financial Intermediation and Delegated Taxation, and Macroeconomic Risk.” RAND Journal of Economics Monituring,” Review of Economic Studies (July 1984), pp.393-414. (summer 1993), pp. 286-303.
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______and ______- “Financial Factors in Business James, Christopher. ‘Some Evidence an the Uniqueness of Bank loans,” Fluctuations,” FinancialMarket Volatility. Fedeml Reserve Bank of JournolafFinoncialEconamics(1987), pp. 217-36. Kansas City, 1988. Jensen, Michael, and William Meckling. “Theory of the Firm: Gorton, Gory, and George Pennacchi. ‘Money Market Funds and Finance Management Behavior, Agency Costs, and Ownership Stuuctum,’ Companies: Are They Banks of the Future?” in Michael Klousner and Journal of Financial Economics (October 1976), pp. 305-60. lawrence J. White, eds., Structural Change in Banking. Irwin Publishing, 1993, pp. 173-214. Koshyop, Anil K., and Jeremy C. Stein. ‘Monetary Policy and Bank lending,” in N. Gregory Mankiw, ed,, Monetary Policy. University of Greenwald, Bruce C., and Joseph E. Stiglitz. “Financial Market Chicago Press for the National Bureau of Economic Research, 1 994a, Imperfections and Business Cycles,” Quarterly Journal ofEconomics pp. 221-62. (February 1993), pp. 77-114. ______and ______. “The Impact of Monetary Policy on Bank ______and ______. “Information, Finance Constsaints, and Balance Sheets,” Camegie-Rochester Conference Series on Public Economic Activity,” in Meir Kohn and S.C. Tsiang, eds., Finance Policy (forthcoming). Constraints, Expectations, and Economic Activity. Oxford University Press, 1988. ______and David Wilcox. ‘Monetary Policy and Credit Conditions: Evidence from the Composition of External Gurley, John, and Edward Show. Money in a Theory of Finance. Finance,” The American Economic Review (March 1993), pp. 78-98, Brookings Institution, 1960. ______Owen A. lamont and Jeremy Stein. “Credit Conditions and ______and ______- “Financial Aspects of Economic the Cyclical Behavior of Inventuries: A Case Study of the 1981-82 Development,” The American Economic Review (September 1955), Recession,” QuarterlyJournal of Economics (August1994), pp. 565- pp. 515-38. 92, Hancock, Diana, Andrew J. loing and James A. Wilcox. ‘Bank Capital King, Robert G., and Charles Plosser, “Money, Credit and Ptices in a Shocks: Dynamic Effects on Secutities, loans, and Capital,” working Real Business Cycle,” The American Economic Review (June 1984), paper (August 1994), Board of Governors of the Federal Reserve pp. 363-80. System. ______and Ross levine. “Finance and Growth: Schumpeter Might Hardauvelis, Gikos, and Thierry Wizman. ‘The Relative Cost of Capital Be Right,” Quarterly Journal of Economics (August 1993), pp. 717-38. for Marginal Firms Over the Business Cycle,” Federal Reserve Bank of New York Quarterly Review (autumn 1992), pp. 59-68. Kiyotaki, Nobuhiro, and John Moore. “Cmdit Cycles.” mimeo (March 1993), london School of Economics. Hart, Oliver, and John Moore. “A Theory of Debt Based on the Inalienability of Human Capitul,” Discussion Paper No. /29(1991), Kliesen, Kevin L, and John A. Totam. ‘The Recent Credit Crunch: The london School of Economics, Financial Markets Group. Neglected Dimensions,” this Review (September/Dctuber 1992), pp. 18-36. Hirtle, Beverly, and Jeanette Kelleher. ‘Financial Market Evolution and the Interest Sensitivity of Output.’ Federal Reserve Bank of New York lamont, Owen S. “Corporate Debt Overhang and Macroeconomic Quarterly Review (summer 1990), pp. 56-70. Vulnerablity,” working paper (1993), Massachusetts Institute of Technology. Hoover, Kevin 0., and Stephen J. Perez. “Post Hoc Ergo Propter Once More: An Evaluation of ‘Does Monetary Policy Matter?’ in the Spirit of James lucas, Robert E., Jr ‘liquidity and Interest Rates,’ Journal of Economic Tabin,’ Journal of Manetury Economics (August 1994), pp. 47J3. Theory (1990), pp. 237-64. Hoshi, Tokeo, Mdl K. Kashyop and David Schanistein. ‘Corporate Structure, lucas, Deborah J., and Robert L McDonald. ‘Bank Financing and liquidity and Investment: Evidencefrom Japanese Panel Data,” Investment Decisions with Asymmettic Information About loan Quarterly Journal of Economics (February 1991), pp. 33-6D. Quality,’ RAND Journal of Economics (winter 1991), pp. 86-1 05. Hubbard, R. Glenn. Money, the Financiol System and the Economy. lummer, Scott, and John McConnell. “Further Fvidence on the Bank AddisomWesley, 1994. Lending Process and Capital Market Response to Bank loan Agreements,” Journal ofFinancial Economics (1989), pp. 99-1 22. ______and Anil K. Kashyap. “Internal Net Worth and the Investment Process: An Application to U.S. Agriculture,’ Journal of Mauskopf, Eileen. “The Transmission Channels of Monetary Policy: Political Economy (June1992), pp. 5D6-34. How They Hove Changed,’ Federal Reserve Bulletin (December 1990), pp. 985-1008. ______and Toni Whited. ‘Internal Finance and Firm Investment,’ Journal of Money, Credit and Banking (forthcoming). Minsky, Hyman P. John Maynard Keynes. Columbia University Press, 1975.
Jaffee, Dwight, and Thomas Russell. “Imperfect Information, ______“Financial Crisis, Financial Systems, and the Performance Uncertainty and Credit Rationing,” Quarterly Journal of Economics of the Economy,” in Commission an Money ond Credit Private Capitul (November 1976), pp. 651-66. Markets. Prentice-Hall, 1964,
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Mishkin, Frederic S. ‘The Household Balance Sheet and the Great ______and ______, ‘Does Monetary Policy Matter?: A New Depression,” Journal of Economic History (1978), pp. 918-37. Test in the Spirit of Friedman and Schwartz,” in Olivier J, Blanchard and Stanley Fischer, eds., National Bureau of Economic Research Mishkin, Frederic S. “Whatoepressed the Consumer?: The Household Macroeconomics Annual. MIT Press, 1989, pp. 121-70. Balance Sheet and the 1973-75 Recessian,” Brookings Popecs on Economic Activity (1977:1), pp. 123-64. Roosa, Robert V. “Interest Rates and the Central Bank,” in Money, Trade, and Economic Growth: Essays in Honor of John H. Williams. Modigliani, Franca, and Merton Miller, “The Cost of Capital, Corporation Macmillan, 1951. Finance and the Theory of Investment,” The American Economic Review (June 1958), pp. 261-97. Ratemberg, Julio J. “AManetary Equilibrium Model with Transactions Costs,” Journal of Political Economy (February 1984), pp. 40-58. Morgan, Donald P. “The lending View of Monetary Policy and Bank loan Commitments,” working paper (July 1993), Federal Reserve Rothschild, Michael, and Joseph E. Stiglitz. “Equilibrium in Competitive Bank of Kansas City. Insurance Markets: An Essay an the Economics of Imperfect Information,’ Quarterly Journal of Economics (November 1976), ______“Asymmetric Effects of Monetary Policy.” Federal Reserve j. 63~49. Bank of Kansas City Economic Review (second quarter 1993), pp. 21-33. Schreft, Stacey. “Credit Controls: 1980,” Federal Reserve Bank of Myers, Stewart, and Nicholas Majiuf. “Corporate Financing and Richmond Economic Review (November-December 1990), pp. 25-55. Investment Decisions When Firms Have Information that Investors Do Not Have,” Journal of Financial Economics (1984), pp. 1 87~221. Shapiro, Matthew 0. “Federal Reserve Palicy: Cause and Effect,” in N. Gregory Mankiw, ed., Monetary Policy. University of Chicago Press, Oliner, Stephen 0., and Glenn 0. Rudebusch. “Is There a Bank Credit 1994, pp. 207-34. Channel for Monetary Policy?” Board of Governors af the Federal Reserve System, Finance and Economics Division Discussion Paper No. Sharpe, Steven. ‘Asymmetric Information, Bank lending, and Implicit 93-B (February 1993). Contracts: A Stylized Model of Customer Relationships,” Journal of Finance (September 1990), pp. 1069-87. ______and ______. “Sources af the Financing Hierarchy for Business Investment,” Review of Economics and Statistics (November Stiglitz, Joseph E., and Andrew Weiss. “Credit Rationing in Markets with 1992), pp. 643-54. Imperfect Information,” The Americon Economic Review (June 1981), pp. 393-410. Owens, Raymond, and Stocey Schreft. “Identifying Credit Crunches,” Federal Reserve Bank of Richmond Working Paper No, 92-I Thornton, Daniel L ‘Financial Innovation, Deregulation and the “Credit (March 1992). View” of Monetary Policy,” this Review (January/Febmary 1994), pp. 31-49. Peek, Joe, and Eric Rosengren. ‘The Capital Crunch: Neither a Borrower Nor a lender Be,” Journal of Money, Credit and Banking (forthcoming). Townsend, Robert. “Optimal Contracts and Competitive Markets with Cosify State Verification,” Journal of Economic Theory (Octaber 1979), ______and ______, “The Capital Crunch in New England.” pp. 265-93. Federal Reserve Bank of Boston New England Economic Review (May-June 1992), pp.2l-3l. Williamsan, Stephen. “Cosdy Monitoring, Optimal Contmcts, and Equilibtium Credit Rationing,” Quarterly Journal of Economics Perry, George L, and Chades L Schultze. ‘Was This Recession Different? (February 1987), pp. 135-45. Are They All Different?” Brookings Papers on Economic Activity (1993:1), pp. 145-211, Wojnilower, Albert, ‘The Central Role of Credit Crunches in Recent Financial History,” Broakings Papecs on Economic Activity (1980:2), Petersen, Mitchell A., and Raghuram G. Ralan. ‘The Benefits of Firm- pp. 277-326, Creditor Relationships: Evidence from Small Business Data,” Journal of Finance (March 1994), pp. 3-38. Zeldes, Stephen P “Consumption and liquidity Constraints: An Empitical Investigation,” Journal ofPolitical Economy (April 1989), Ramey, Valerie. “How Important is the Credit Channel in the Transmission pp. 30546 of Monetary Policy?” Carnegie-Rochester Conference Series on Public Policy (December 1993), pp. 1-45. Romer, Chtistino 0., and David H. Romer. ‘Credit Channel or Credit Actions?: An Interpretation of the Postwar Transmission Mechanism,” in Changing Capital Markets: Implications for Monetary Policy. Federal Reserve Bank of Kansas City, 1993.
______and ______. ‘New Evidence on the Monetary Transmission Mechanism,” Brookings Papecs on Economic Activity (1990:1), pp. 149213.
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THE FINANCIAL ACCELERATOR AND THE CREDIT VIEW
There are three basic conclusions of cave (wheref(O) = O,f’(O) = oo, andf’(z) — 0 models of financial frictions relating to asym- as z —~ 00); ira + gb = 1; 0
(such as organizational or maintenance The value of K that satisfies equation A2 — expenditures). The production technology call it K*_ does not depend on any financial is risky, with two possible productivity states, variables; that is, the Modigliani and Miller “good” and “bad”; uncertainty is realized theorem applies. after the investment decision is made. The traditional interest rate channel To make the example as simple as possi- often identified with the money view mecha- ble, suppose the firm can increase the chance nism is easy to illustrate in this example. of a good output realization if it uses a stnffi- Suppose for simplicity that the interest rate cient quantity of soft capital, where sufficient paid on deposits is zero, so that a- represents is defined by a level proportional to the the gross required rate of return on lending. quantity of hard capital used, In particular, To the extent that an open market sale raises let output Y satisfy: a-, investment demand falls, This is the usual textbook interest rate channel for monetary (1A) Y =f(K), with probability tar, policy Under asymmetric information, the and story is more complicated. Consider, for Y = cvf(K), ~th probability lrr~, example, a simple agency problem: if Expenditures on hard capital are observable C vK, by outside lenders, while expenditures on and soft capital are not. In this case, the manager may be tempted to divert soft capital funds (2A) Y= crf(K), to personal gain. Such perquisite consump- if tion can take a number of forms. For sim- CCvK, plicity assume that the manager can invest wherejKK) is twice continuously differen- the funds (say in a Swiss bank account) to tiable, strictly increasing, and strictly con- yield a gross interest rate, a-.
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Lenders understand this temptation, to cheat is to increase the amount of ph that and modify the financial contract to mitigate the firm must pay the intermediary in the incentives to cheat. As shown below, one event of a bad outcome, The firm, however, consequence of this modification is that desired can only credibly promise to pay available capital, K*, may exceed actual capital, K, and assets in the bad state, That is, a limited lia- this gap will depend inversely on the bor- bility constraint influences the contract: rower’s net worth. Suppose the firm signs a 5 (7A) p ~ af(K)+V loan contract with a competitive financial intermediary The firm has some initial liq- To summarize, the contracting problem 5 5 uid asset position, W, and collaceralizable involves the selection of K, P and P to max- future profits, V, in period one, worth a pre- imize equation 4A subject to equations 5A, sent value of Via-. Hence, the firm’s initial net flA and 7A. One case is easy: As long as the worth is (W + Via-). To make the story inter- incentive constraint does not bind, actual esting, assume that W
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see the former, note an increase in lenders’ (3) For bank-dependent borrowers, the avail- opportunity cost of funds on account of a ability of monitored bank credit can be monetary contraction reduces desired invest- thought of as a substitute for internal net 5 ment K* (since K* is determined by (ia + worth. Changes in the availability of bank 5 zr cc)f’(K) = (1 + v)a-). To see the latter, note credit can influence the ability of bank- that, to the extent that banks face ahigher dependent borrowers to finance spending. marginal opportunity cost of funds because of (4) The model’s intuition can apply to banks a less than perfectly elastic supply schedule as well as nonfinancial borrowers. A for managed liabilities (and borrowers lack decline in banks’ net worth raises banks’ access to nonbank finance), the increase in a- opportunity cost of external funds (say in lowers both desired and actual investment. the CD market). Asa result, the cost of This simple framework is consistent funds to bank-dependent borrowers rises. with the description of the flitancial accelerator (5) If relationships between borrowers and mechanism: The cost of uncollateralized specific banks are important, shocks to external finance exceeds that for internal the balance sheet positions of individual finance. This gap varies inversely with the lenders affect credit availability (at any internal net worth of the borrower and a given open market interest rate) to their decline in net worth reduces the borrowers’ borrowers, spending, all else equal. The framework also yields simple testable predictions related to these money view and credit view arguments: (1) When informational imperfections are ignored, an increase in real interest rates following a monetary contraction should affect investment (broadly defined) simi- larly for borrowers of a given type (for example, with similar technology and risk characteristics). (2) If informational imperfections are signif- icant only on the borrower side, all else equal, spending by borrowers with lower levels of internal net worth should fall relative to spending by borrowers with higher levels of internal net worth.
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