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1  Introduction

To conduct monetary and fiscal policies successfully, policy makers must have an accurate assessment of the timing and effects of their policies on the economy. This includes an understanding of the monetary transmission mechanisms through which monetary policy affects the decisions of firms, households, financial intermediaries and investors that alter the level of economic activity and prices. This paper argues that macroeconomic models currently used by policy makers are too limited in describing the transmission mechanisms and points to new directions.

Interest and exchange rates are the prototypical channels through which monetary policy affects the economy in contemporary models used by policy makers.[1] The assumption in these models is that the workings of financial markets can be fully summarized by financial prices, because the Modigliani and Miller (1958) theorem holds.

Under the assumptions that financial markets are complete and information and transaction costs are non-existent, the Modigliani and Miller (1958) theorem states that the mix of debt and equity used to finance firms’ expenditures does not affect the expected profitability of the project – the same investment decisions would be made, irrespective of the mix of debt and equity finance. Fama’s (1980) extension of the Modigliani-Miller theorem to the entire financial system allows the abstraction from considerations of credit market conditions in macroeconomic models.

While the complete market assumption remains important in economics, the assumption of zero information and transaction costs (or perfect information) has come under increasing criticism since Akerlof’s (1970) seminal paper, which illustrated how imperfect information between buyers and sellers can cause market malfunctioning. With imperfect information, the market price reflects buyers’ perception of the average quality of the product being sold, and sellers of low quality products will receive a premium at the expense of those selling high quality goods. As a result, some high quality sellers will stay out of the market, which will lower the average quality of the product and price of the product even further, leading more high quality sellers to stay out of the market. The process will continue and may preclude the market from actually opening. Efficient markets require some mechanisms for overcoming the imperfect information problem.

In financial markets, an information asymmetry arises between borrowers and lenders because borrowers generally know more about their investment projects than lenders do. Intermediaries, which specialise in collecting information, evaluating projects and borrowers, and monitoring borrowers’ performance, can help overcome the information problem. Financial intermediaries thus exist because there are information and transactions costs that arise from imperfect information between borrowers and lenders. This implies that the assumptions upon which the Modigliani-Miller theorem is based, and thus the macroeconomic models used by policy makers, do not hold. Conditions in financial and credit markets can affect the real economy; and interest and exchange rates are an incomplete description of the monetary transmission mechanism.

The remainder of the paper proceeds in six further sections. Section 2 describes the standard interest and exchange rate channels of the monetary transmission mechanism as they are typically incorporated in macroeconomic models. These channels are too limited as they abstract from credit market interactions. The idea that the credit creation process can have real economic effects is not new and section 3 reviews traditional theories of the role of credit markets including Wicksell’s early writings on monetary dynamics and Fisher’s (1933) “debt-deflation theory of great depressions”. Current theories are discussed in section 4 and the credit channel of the monetary transmission mechanism as it is currently characterised in the literature is described in section 5. A number of dynamic general equilibrium models that account for an explicit role of credit market frictions in business cycle fluctuations have been developed recently. These are discussed in section 6. None of the models is complete and section 7 summarises and concludes with a brief assessment of avenues for future research.


  • [1]See, for example, the Reserve Bank of New Zealand’s Forecasting and Policy System (Black, Cassino, Drew, Hansen, Hunt, Rose and Scott, 1997), the New Zealand Treasury NZTM model (Szeto, 2002), the Federal Reserve Board of Governors’ FRB/US model (Brayton and Tinsley, 1996), the International Monetary Fund’s MULTIMOD model for industrial countries (Laxton, Isard, Faruqee, Prasad and Turtelboom, 1998), the Bank of Canada’s Quarterly Projection Model (Black, Laxton, Rose and Tetlow, 1994) or the Australian Treasury’s TRYM model (Commonwealth Treasury 1996a, 1996b).
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