Summary

Bernanke and Gertler (1995)

Inside the Black Box: The Credit Channel of Monetary Policy Transformation

Consensus on money supply Y in the short run but exactly how is a

black box when tested empirically.

Textbook story:
MP short term interest rate cost of capital
spending on durable goods (AD) Y or production

4 standard facts about how the economy responds to MP shocks (given money
supply)
1. transitory effects on interest rates but sustained in real GDP and price level
2. final demand absorbs in money supply initially, but production follows with a
lag.
inventory stocks in the short run
(ultimately) inventory stocks (disinvestment accounts for a large portion
of GDP)
3. earliest and biggest declines in financial demand:
top 1 - residential investment, top 2 - consumer goods
4. Fixed business investment1 (eventually) but its fall lags behind housing and
consumer durables and much of the in production and interest rate

Used VARs to test these facts and they all hold. (see yellow pad for details)

Some notes: Fed has leverage over the short term real rate because prices are
sticky
real rates aggregate demand
Slow response of GDP deflator and quick response of final demand; durables are
very responsive

But there are gaps:

1) weak cost-of-capital effects in estimated spending equations
difficult to empirically identify the effect of the neoclassical cost of capital variable 2;
non-neoclassical factors3 have greater impact on spending; empirical test of Tobins
q formulation of the neoclassical model also not that successful
2) expectation: theory says MP has a bigger effect on short run interest rates than
long-term ones; reality: long-lived assets (housing, production equipment), which
are responsive to long-term rates, respond more.

1 Equipment investment accounts for almost all the decline in fixed investment;
structures investment less responsive)

2 (real rate of return +depreciation rate)*[price of new capital good] = the

neoclassical cost of capital

3 accelerators like lagged output, sales or cash flow

Puzzles:
1. Magnitude of the policy effect (small OM interest rates real economy) (even
if there are no strong cost-of-capital effects on components of private spending in
empirical studies)
2. timing
Interest rate spike is transitory, important spending components do not react until
after most of the interest-rate effect is past4 (e.g., bulk of business fixed investment
responds 6 to 24 months after the shock); explains why its hard to pin down robust
effects of interest rates on spending
3. composition of spending effects most rapid and strongest effect of monetary
policy is on residential investment (puzzling because these are associated with long
term interest rates) and another type of long-lived investment (business structures
investment) not affected much.

The credit channel5 of monetary transmission mechanisms that take into account
imperfect information and other frictions in credit market to explain impact of MP
on output

We know that MP short term interest rate but the

is amplified by endogenous changes in the
EXTERNAL FINANCE PREMIUM
= cost of externally raised funds cost of internally generated funds
= wedge between cost of funds raised externally and the opportunity cost of
internal funds
= wedge between the expected return to the lender and the costs faced by the
borrower
- reflects imperfections in credit markets
- reflects deadweight costs associated with principal-agent problem between
borrower and lender
- lemons premium
- cost of distortions in borrowers behavior stems from moral hazard/restrictions in
contract intended to contain moral hazard (see p. 35 for examples)
MP short term interest rate AND
MP EFP (same direction)

MP impact on overall cost of borrowing is magnified and also on real

spending/output/activity

Why does the CB have an effect on credit markets?

2 linkages:
Balance sheet channel (on balance sheets and income statements like the net worth
of borrower, cash flow, liquid assets)
Bank lending channel (on supply of loans by depository institutions) (controversial;
institutional changes have made this less plausible, but others increased its
importance)
4

5 Misnomer because its not a distinct or different channel but a set of factors that
amplify and propagate conventional interest rate effects
Balance sheet channel EFP depends on borrowers financial position
As net worth, EFP (affects terms of credit)
quality in balance sheets investment and spending decisions
Endogenous pro-cyclical movements in borrowers balance sheets can amplify and
propagate business cycles a phenomenon called financial accelerator (balance
sheet and cash flow variables link to fixed investment, inventories, and other factor
demands)
MP affects not just interest rates but also the financial positions of borrowers
directly and indirectly