Monetary policy and bank lending.

• Author: Bernanke, Ben

Over the last decade or so, NBER researchers have analyzed the effect of financial conditions, particularly the characteristics of borrowers' and lenders' balance sheets in macroeconomic performance.(1) The result, I believe, is a much richer understanding of the sources of aggregate fluctuations. For example, ten years ago the leading theory of the determination of business fixed investment implied that the main factors affecting investment were the marginal product of capital and the real interest rate. Absent large unexplained fluctuations in capital's marginal product, this neoclassical theory was hard pressed to explain the volatility of investment over the business cycle. Recent empirical research has shown instead that balance sheet conditions, such as the firm's indebtedness or its access to internal finance, have a major influence on its investment decisions.(2) It seems likely that cyclical changes in balance sheets or cash flows, perhaps in interaction with the illiquid nature of capital investments, ultimately will provide an explanation of the cyclical volatility of investment spending that is superior to what the neoclassical model can offer.

The research I report on here, on the link between monetary policy and commercial bank lending, is a relatively small subtopic of this larger research program on financial-real interactions. It shares with the larger program the idea that balance sheets matter, as well as the broader conviction that--because the structure of financial arrangements affects the transmission of information and the incentives of market participants--financial conditions do have effects on the real economy.

The Channels of Monetary Transmission: Money Versus Credit

The question I take up here is a very old one: how does monetary policy affect aggregate demand? The standard answer is that the Federal Reserve works its magic by changing the supply of the medium of exchange relative to the demand. According to this story, to slow down the growth of aggregate demand (for example), the Fed uses open market sales to drain reserves from the banking system, reducing the money supply. This shortage of liquidity is presumed to drive up short-term--and possibly, through expectational effects, longer-term--interest rates. Higher interest rates are then presumed to depress aggregate demand by raising the cost of funds relative to the returns to capital (including housing and consumer durables). I will refer to this standard channel as the "money channel" of monetary transmission.

Without necessarily denying the existence of this conventional money channel, recent research has addressed the possibility that there is an additional channel of monetary policy transmission, which I will refer to as the "credit channel." In contrast to the money channel, which operates through the liabilities side of bank balance sheets (deposits), the credit channel (if it exists) operates through the asset side of the bank balance sheet (loans and securities). This credit channel relies on two assumptions.

The first is that banks do not treat loans (for example, to commercial and industrial firms) and securities (such as Treasury bills) as perfect substitutes in their portfolios. This assumption is quite realistic: banks hold securities primarily for liquidity, for collateral, and to satisfy various legal requirements, while loans are held primarily for their expected return.

The second assumption is that potential borrowers, such as business firms, are not indifferent between bank loans and the issuance of open-market securities, such as equities or corporate bonds, as a means of raising funds. Again, this assumption is realistic: many firms, especially smaller ones, have essentially no access to open-market credit and must rely entirely on banks or other intermediaries for funds. In...