Credit Markets and the Propagation of Monetary Policy Shocks

JEL Classification: E50

Keywords: Credit, Monetary policy shock, Heterogeneous agents

1 Introduction

This paper analyzes the propagation of monetary policy shocks through the cre-
ation of credit in an economy. There is a vast literature on the transmission mech-
anism of monetary shocks. The empirical strand of this literature has identified
two stylized facts about the response of macroeconomic variables to unexpected
changes in the monetary conditions of the economy:

1. Monetary policy shocks may have sizeable impacts on aggregate activity;
and,

2. These effects propagate over time, with responses of macroeconomic variables
having a hump shape that peaks at four to six quarters after the shock.

There is a growing theoretical literature that tries to build up models to generate
these two empirical facts. Usually, the modeling choices are as follows. To get
monetary policy to affect the real activity in the short run, some sort of friction in
the model is needed. This is accomplished by assuming that agents cannot adjust
in the short run some nominal variable such as prices, wages or the asset compo-
sition of portfolios. It is typical in models with these features that responses are
immediate and last for a few quarters only. To propagate the impact of monetary
shocks over time, these models introduce adjustment costs by which agents find it
optimal to change their decisions slowly.

This paper presents another explanation of the two stylized facts mentioned
above that does not rely on any sort of stickiness or adjustment costs. Our inter-
pretation is based on the way credit is created and how the monetary conditions in
an economy affect the process of financial intermediation. In our economy, there
is a population of agents who accumulate assets and choose between two different
occupations. On the one hand, an agent may decide to be a worker which means
he will provide labor services and lend out his assets. On the other hand, an agent
may decide to be an entrepreneur. In this case, he will need to finance an invest-
ment plan but will face financial constraints in the form of collateral for the project.
Agents face idiosyncratic productivity shocks which generate an endogenous dis-
tribution of assets within the population. Because we assume decreasing returns
to scale, the inability of some entrepreneurs to achieve their optimal firm size due
to the financial constraint will result in an inefficient allocation of resources.

In this economy, capital is distributed among agents through the use of nomi-
nal units of account created by financial intermediaries. Entrepreneurs with a low

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