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May/June 1995, 
Vol. 77, No. 3
Posted 1995-05-01

Distinguishing Theories of the Monetary Transmission Mechanism

by Stephen G. Cecchetti

The author surveys the credit channel for monetary policy. He makes clear that there are two possible credit channels for monetary policy, and that both require asymmetry in the access of “small” and “large” firms to credit. The bank credit channel operates directly on the ability of depository institutions to make loans through the effect of monetary policy actions (open market operations) on bank reserves. For example, restrictive monetary policy actions reduce reserves and, thereby, loans. Unable to obtain bank or other external finance, bank dependent firms curtail planned spending. The second credit channel, which goes by various names (such as the financial accelerator, excess sensitivity or the broad lending view), works through the effect of a policy induced change in interest rates on the balance sheets of borrowers. For example, by reducing their real net worth, a policy-induced increase in the real interest rate makes it difficult for some, typically smaller, firms to attract capital. Unable to attract funds, these firms curtail planned spending. This view differs from the traditional analysis, whereby a policy-induced increase in interest rates makes marginal investment opportunities unprofitable. The author focuses on the aggregate evidence and frames his analysis in an interesting discussion of the difficulties associated with identifying changes in monetary policy, an analysis of several commonly used indicators of policy, and a discussion of how to differentiate alternative views using both aggregate time-series and cross-sectional data.