The Bank Lending Channel
Macro-Economic Policy
University of Lausanne
Fall 2013
Macro-Economic Policy
The Bank Lending Channel
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Introduction
Bank Lending Channel
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Beyond its impact on firms’ balance sheets, monetary policy may also
affect the external finance premium by shifting the supply of credit
Firms are captive due to the central role played by banks in
intermediation
Banks contribute to lower informational and monitoring problems due
to asymmetric information
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The Bank Lending Channel
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Introduction
Start with a standard IS/LM model
Introduce intermdiation into the IS/LM
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Bernanke Blinder (1998) - Credit, Money, and Aggregate Demand
Study the effects of monetary policy on banks
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The Bank Lending Channel
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Standard IS / LM - No Credit Friction
Let’s begin in a world without credit frictions
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1 consumption good
2 assets: money M and bonds B
4 types of agents: households, firms, banks, government
Two key variables:
households’ income Y
interest rate on bonds rB
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Households and Firms
Household savings equals bank deposits and bond holdings
S(Y , rB ) = D h (Y , rB ) + B h (Y , rB )
Assumptions on the functional forms
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Deposits increase with income Y and decrease with the interest rate on
bonds rB
Bond holdings increase with both Y and rB
Savings increase with both Y and rB (bond holding effect dominates)
Firm investment is financed by bond issues
B f (rB ) = I (rB )
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Firm investment decreases with the interest rate
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Banks
Bank Balance Sheet
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D h : household deposits, R: reserves, B b : bonds
R + Bb =
| {z }
Bank assets
Dh
|{z}
Bank liabilities
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Reserve requirement: Banks are obliged to hold a minimum amount of
reserves (money base)
R = ↵D h
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If banks don’t hold any excess reserves, then reserves and bonds are
related by
R
1 ↵
Bb =
R=
R
↵
↵
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Government
Government revenues come solely from seigniorage (reserves R)
Current government spending equals revenues R plus issued debt B g
G = R + Bg
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very stylized view of the government budget constraint.
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Market Clearance
g
b
Bond market: B
+ B }f = B
+ B h}
| {z
| {z
Supply
Demand
Money market (LM): R = ↵D h (Y , rB )
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Implies positive relationship between Y and rB
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Because of the binding constraint, deposits do not respond to interest
rate fluctuations
When rB increases, Y must rise to keep D h from falling
Good market (IS): I (rB ) + G = S(Y , rB )
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Implies negative relationship between Y and rB
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Hold Y fixed. When rB increases, investment falls but savings increase
Since G is fixed, Y must fall to bring down savings.
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The Effect of a Monetary Expansion
What happens if the reserves of the banks increase?
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Excess supply of money implies the interest rates on bonds must
decrease
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LM curve shifts down and right
Output and Investment increase
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Equilibrium allocation lower down the IS curve
Monetary policy affects economic activity through reserves (money
market)
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What about the bond market?
Government: Increasing R while holding G constant requires less
government bonds
Banks: R stimulates the demand for bonds by banks
Excess demand for bonds (counterpart of excess supply of money)
lowers the interest rate
Firms invest more and households buy less bonds.
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NB: Loans to firms and bonds are perfect substitutes
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The Bank Lending Channel
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Introduce Credit Frictions
Assumptions
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Only banks can lend to firms.
2
Loans are imperfect substitutes for bonds
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Market Segmentation
Segmentation in credit markets:
rL 6= rB
Firm investment is exclusively financed through loans from banks
Lf (rL ) = I (rL )
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Firm investment decreases with the interest rate on bank loans
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Bank Balance Sheet
Bank Balance Sheet
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D h : household deposits, R: reserves, B b : bonds, Lb : loans
R + Lb + B b =
|
{z
}
Banks’ assets
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Dh
|{z}
Banks’ liabilities
Banks are obliged to hold a minimum amount of reserves (money base)
R = ↵D h
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No excess reserves implies B b + Lb =
Macro-Economic Policy
1 ↵
↵ R
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Bank Portfolio
Assume banks apply the portfolio rule
Lb = µ(rB , rL )
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1
↵
↵
R
B b = [1
µ(rB , rL )]
1
↵
↵
R
Assume µ(rB , rL ) decreases with the interest rate on bonds and
increases with the interest rate on loans
This functional assumption has nice properties
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Bank supply of loans increases with the interest rate on loans and
decreases with the interest rate on bonds.
Bank demand for bonds increases with the interest rate on bonds and
decreases with the interest rate on loans.
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Market Clearance
b
Bond market: |{z}
Bg = B
+ B h} (no B f )
| {z
Supply
Money market (LM): R
Demand
= ↵D h (Y , r
B)
(no change)
Good market (IS): I (rL ) + G = S (Y , rB ) (no change)
Loan market: I (rL ) = Lb = µ(rB , rL ) 1 ↵↵ R (new equation)
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implies the interest rate on loans is increasing in the interest rate on
bonds and decreasing in the amount of reserves
rL = (rB , R)
Macro-Economic Policy
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>0
2
<0
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The Effect of a Monetary Expansion
We can substitute rL in the (IS) equation:
I ( (rB , R)) + G = S(Y , rB )
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CC equation (Commodities and Credit, Patinkin 1956)
Difference with traditional IS: affected by R
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falls as R rises, boosting investment on its own
An increase in investment demand implies, for a given rB , Y must be
higher.
amplification of monetary policy through the credit channel
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Works the other way around as well, monetary contractions may lead
to severe crises
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How does the credit channel work?
If reserves increase, then the loan to bond interest rate spread rL
falls.
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rB
Increase in the reserves available to banks increases the supply of loans
Insufficient demand for loans lowers the loan rate rL
Increase in the reserves available to banks increases their demand for
bonds
However, household demand for bonds decreases as the interest rate
falls, so the increase in demand of bonds by banks does not require
such a large decrease in rB .
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A Financial Crisis
Suppose
spikes (banks are scared: a reduction in µ)
IS curve shifts to the left sharply
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Interest rate on bonds falls
Interest rate on loans spikes
Monetary Policy Response: increase R
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Interest rate on bonds continues to fall
Interest rate on loans stays high
Liquidity Trap: What to do?
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Keep increasing R, credit channel may still be active
Does this work? Unclear
Other option: quantitative easing (next lecture)
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The Bank Lending Channel
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