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On the role of firm balance sheets in the transmission mechanism

A growing literature assesses whether or not financial constraints play an important role in the transmission mechanism of monetary policy. The lending channel presumes that the effect of monetary policy on bank loan supply is amplified by the presence of agency problems. Draining deposits from banks will reduce lending if banks face financial constraints when attempting to smooth these outflows by issuing large CDs and federal funds. When long-standing relationships provide banks with information advantage about the quality of their borrowers, firms find the credit offered by other banks to be an imperfect substitute. A monetary contraction therefore has much larger effects on the investment of bank-dependent firms than what is implied by the actual change in policy interest rates. The balance sheet channel, on the other hand, traditionally hypothesizes that monetary policy affects loan demand through its effect on firms' net worth. Higher interest rates increase debt service, erode firm cash flow, and depress the value of collateral, exacerbating conflicts of interest between lenders and borrowers. This deterioration in firm creditworthiness increases the external finance premium and squeezes firm demand for credit. Either of these channels would provide an explanation for how the typically small and transitory changes in policy interest rates have long and lagged effects on the real economy in the presence of weak measured cost of capital effects on investment.