effects on their consumption decisions), the investment decisions of firms that are quoted at
the stock market are also affected. Following this theory, the main source of differences in
monetary transmission will be related to the extent to which the agents hold financial assets
whose prices may vary in reaction to unexpected changes in monetary policy.
However, these channels of monetary transmission (or at least the most traditional: interest
rate and exchange rate) have recently received considerable criticism as it is assumed that
credit markets tend to come back to equilibrium. In fact, the main criticism to the previous
approaches is related to the assumption of perfect information and the lack of consideration of
incentive problems. In this alternative view, financial prices do not clear the credit market
(Bernanke and Gertler, 1995). This approach to the transmission process is known as the
credit channel. In this case, the efficient functioning of the market credit is hindered by
asymmetries in information between borrowers and lenders, resulting in principal-agent
problems. These problems lead to endogenous and varying credit conditions with help to
shape the transmission of monetary policy decisions to economy. This uncertainty generates a
potential important role for financial intermediaries who specialise in gathering and distilling
agent-specific information. The implication is that financial intermediaries, usually banks,
play a unique role in the monetary transmission process, acting as an interface between the
policy decisions of the central bank and non-financial activity.
Bernanke and Gertler (1995) emphasise how asymmetric information and costly enforcement
of contracts creates agency problems in financial markets. Two basic channels of monetary
transmission arise as a result of agency problems in credit markets: the bank lending channel
and the balance-sheet channel.
The bank lending channel is based on the view that banks play a special role in the financial
system because they are specially well suited to deal with certain types of borrowers,
especially small firms where the problems of asymmetric information can be very
pronounced. In this context, the relationships between small firms and banks play a strategic
role in the transmission of monetary policy. The way this channel works is the following:
assuming that the total available quantity of credit is limited, a restriction of bank credit will
restrict the investment possibilities of small firms (but not for large firms as they can access to
credit through stock markets), translating the restrictive effects, through multiplier-effects, to
the rest of the non-financial sector.