Credit Markets and the Propagation of Monetary Policy Shocks



level of assets borrow these units of account to obtain extra capital for their firms.
In this sense, the nominal interest rate represents a cost of production. When cre-
ating credit, banks have to satisfy reserve requirements. The monetary authority
provides these banks with two types of liabilities: 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) liabilities of the central bank.

One of the crucial features that allows monetary shocks in our model to generate
a sizeable contemporaneous response of output is the existence of idle capital.
There are several possible interpretations to rationalize the presence of unused
resources. One is the limitations firms may encounter to modify their capacity
to produce goods in the short run. This may happen if firms face uncertainty
about demand at the time of capacity choices, an idea developed, among others,
by Fagnart, Licandro and Portier [11] and applied to a monetary environment by
Alvarez Lois [1]. This also may happen if there are costs of producing at full
capacity. To make our model simple, we pursue another interpretation. In our
model, the government needs to finance its liabilities. In the process it bids up
the interest rate and absorbs assets which otherwise would have ended up in the
production sector financing the use of productive capital.

An expansionary monetary policy is associated with an increase of reserves over
bonds. Financial intermediaries learn that the supply of reserves have increased
which gives them the possibility of expanding credit. However, the government is
borrowing less through debt so banks will have to give these credits to entrepre-
neurs. Given that the interest rate is a cost to entrepreneurs borrowing credits, the
only way to convince them to borrow more is by reducing the lending rate. This
change produces several effects. First, some of the idle assets that were not used
before are now available to finance productive capital. Also, lower interest rates
make constrained firms borrow more and resources are moved from entrepreneurs
with low productivity to high productive ones. As the economy adjusts to the new
environment, aggregate variables behave in a way that resembles an expansionary
phase of the cycle.

We understand this mechanism depends on the existence of idle assets due to
the presence of reserves and bonds. However, we believe it should apply indepen-
dently of the reason why a proportion of the productive capacity of the economy
is not used to start with. The reason is that our mechanism works through a
channel which is present in any of these other interpretations, namely, an expan-
sionary monetary shock makes it cheaper to finance the use of productive capital
and, therefore, will push the economy towards a more intensive utilization of these
resources.

Since the seminal contribution of Bernanke and Gertler [2], a strand of the liter-
ature has analyzed the macroeconomic implications of financial frictions with mod-
els where financial constraints arise endogenously (see, among others, Bernanke,



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