Credit Markets and the Propagation of Monetary Policy Shocks



economy where the monetary shocks propagate in a similar way as we find in the
data. Interestingly, the internal propagation mechanism in the model does not
rely on any sort of stickiness or adjustment costs. Our interpretation is based on
the way credit is created and how the monetary conditions in an economy affect
the process of financial intermediation.

In our model, there is a distribution of agents who accumulate assets that may
be used as capital for production purposes. Capital is distributed among agents
through the use of nominal units of account created by financial intermediaries.
Entrepreneurs with a low level of assets borrow these units of account to obtain ex-
tra capital for their firms. In this sense, the nominal interest rate represents a cost
of production. Furthermore, there is no possibility of default in financial contracts
which force entrepreneurs to have enough collateral to cover potential negative
profits. Thus, borrowers with very low levels of accumulated assets relative to
their investment needs may be constrained in their borrowing activities.

When creating credit, banks have to satisfy reserve requirements. The mone-
tary authority provides these banks with two types of assets: reserves and bonds.
We show that the relevant policy variable to determine the level of interest rates
is the ratio of liquid (reserves) to illiquid (bonds) government liabilities. An ex-
pansionary monetary policy is associated with an increase in this ratio. Thus, an
outright open market operation by which the central bank buys government bonds
in exchange for reserves frees financial resources that can be used by entrepreneurs
to increase the amount of capital they employ. In particular, this monetary policy
shock relaxes the financial restriction of constrained entrepreneurs allowing them
to borrow more capital and to produce more. As the distribution of assets among
agents changes in time, this disturbance sets in motion a response of the economy
that resembles an expansionary phase of the cycle.

The basic propagation mechanism is the ability of constrained entrepreneurs to
accumulate more assets which relaxes their financial constraint also in the future
and allows them to maintain higher levels of production. Additionally, in our
simulation profits are small as compared to wealth so the distribution of asset
ownership takes time to change. This also contributes to propagating shocks over
time. We have shown that this mechanism is able to generate sizeable effects on
real activity with responses that are persistent as we observe in the data.

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