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World financial system

World financial systems have changed and now monetary transmission mechanisms have other distributional effects that are not addressed within the traditional money view. Firstly, I shall explain the distributional aspects of the traditional money view and then that of the credit channel, exchange rate channel and other asset price effects. The traditional money view is an interest rate based channel, featured by the standard Keynesian IS-LM framework with exogenous money supply (www. erc. metu. edu. tr/menu/series02/0203. pdf). The basic assumptions that characterize the interest rate channel are:

i) sticky-price adjustment to money supply shocks, ii) direct control of the monetary authority on nominal money supply by adjusting reserves, and iii) presence of two assets such as money and bonds where loans are perfect subtitutes for bonds. The IS-LM view of money stresses that changes in the policy are important only insofar as they affect aggregate outcomes. Investment flactuations are of importance since policies only affected the required rate of return on new investment projects. Hence a monetary policy tightening (Mcauses the interest rate to rise. The rise in interest rates cause investment spending to fall (I.

This is a leftward movement along the the investment schedule from I0 to I1. Consequently, the

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aggregate demand and output fall (Y). Fig. 1. (a), (b) and (c) explain the transmision. Under this framework, investment includes residential housing and consumer durable expenditure and business investment as well. The schematic of the distributional effects is: M, The transmission mechanism under this view works through the liability side of the bank balance sheets. Three conditions are necessary for the money channel to work. First, banks can not perfectly shield transaction balances from changes in reserves.

Second, there is no close substitute for money in the conduct of transactions in the economy. Thirdly, it makes no difference which type of assets banks hold. Fig. 2 shows the transmission through the major channels. The traditional view however has inefficiencies. Firstly, in the IS-LM analysis, the bond market is assumed to be in equilibrium. Banks have a primary role of providing capital for businesses but the model totally ignores the banks involvement in the economy. Furthermore, in a modern economy firms have different sources of finance (41MY lecture notes).

Second, there is no strong evidence that business investment in particular is interest sensitive. The model also fails to explain why short-term interest rates affect spending durables such as housing which presumably depend on the long-term rate. Fourth, empirical evidence has shown significant output changes following a change in the interest rate, simultaneously the cost of capital measures appear insignificant in explaining individual expenditure components. Lastly there is a response lag in the economy following an interest rate change.

Bernanke and Gertler (1995) state that the effect of a monetary policy shock on interest rate is transitory, while some components of GDP do not change until after the interest rate returns to its trend. The traditional view does not address why real variables continue to adjust after most of the rise in short-term interest rates have been reversed. The credit channel however, is an enhancement mechanism and emphasizes how asymmetric information and costly enforcement of contracts creates agency problems in the financial markets (Bernanke and Gertler (1995)).

It describes how an external financial premium (set by banks), which is a wedge between the cost of funds raised externally (by issuing equity or debt) and the opportunity cost of funds raised internally (retained earnings), has an important role in economic activities. The size of an external finance premium reflects imperfections in credit markets that drive a wedge between the expected return received by lenders and the costs faced by potential borrowers. Monetary policy, which alters interest rate, tends to affect the external finance premium in the same direction.

Thus, the direct effects of the monetary policy on interest rate are amplified by changes in the external financial premium. This complimentary movement in the external finance premium may help explain the strength, timing, and composition of the monetary policy effects better than a reference to interest rates alone (http://wb-cu. car. chula. ac. th/papers/transmission. htm). The influence of monetary shocks on the real economic activity has two dimensions in the credit view.

First, a monetary shock can influence the financial position or the net worth of a borrower firm. A higher net worth of a firm’s balance sheet makes external financing from the loan market cheaper and stimulates investment. As the transmission mechanisms of the monetary shocks to the real economy operate through the borrowers’ balance sheets, this transmission mechanism is called the bank balance sheet channel. Second, a monetary shock can influence the banks loan supply to the bank-dependent firms (http://www. erc. metu. edu.

tr/menu/series02/0203. pdf). A change in the availability of loans influences investment decisions by borrower firms by reducing the external sources of finance. This is the bank lending channel. The balance sheet channel is based on the fact that a firm’s investment decision is based on the firm’s financial position which is affected by underlying monetary shocks. That is, the greater the borrower’s net worth, the lower external financial premium should be. Monetary policy tightening directly weakens borrowers’ balance sheets in at least two ways.

First, rising interest rates (idirectly increase interest expense repayments, reducing net cash flows (CF) and weakening the borrower’s financial position. Second, rising interest rates are also typically associated with declining stock prices (Ps, which reduce the value of the borrower’s collateral. Indirectly, monetary policy tightening affects net cash flows and collateral values from deterioration in consumers’ expenditure. The firm’s revenues will decline while its various fixed or quasi-fixed costs do not adjust in the short run.

The financing gap, therefore, erodes the firm’s net worth (NW) and credit worthiness over time. Lower net worth means that lenders in effect have less collateral for their loans, and so losses from adverse selection are higher. Decline in net worth raises the adverse selection problem, thus leading to a decrease in lending (L to finance investment spending. Gertler and Gilchrist (1993, 1994) found this monetary policy tightening to affect smaller firms more because they had limited access to short-term credit markets.

Lower net worth of firms also increases the moral hazard problem because firms’ equity stakes are low, so there is a high incentive for firms to engage in risky investment projects. Since taking on risky projects reduces the likelihood of loan repayments, decrease in net worth leads to a decrease in lending and thus investment and output. The schematic for this mechanism is: MPs Or Mi. The bank lending channel specifically affects small to medium sized firms who have few or no alternative sources of finance other than bank loans.

Any frictions in the asset-liability management of banks due to monetary shocks would be transmitted to real economic activity through the bank dependent producers in the economy. Monetary policy tightening leads to reduction in the volume of deposits and short run sell-off of banks’ security holdings, with little effect on loans. Overtime banks respond by terminating old loans and refusing to make new one. Since small and medium sized firms are dependent on bank loans for credit, reduction in the loan supply can depress the economy (Bernanke & Blinder 1992).

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