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Asymmetric Information, Financial Intermediation and the Monetary Transmission Mechanism: A Critical Review - WP 03/19

6  General equilibrium models of the credit channel

Financial intermediaries exist because of imperfect information between borrowers and lenders. Modelling asymmetric information is difficult and probably the main reason why macroeconomic models currently used by policy makers do not incorporate a fully developed credit channel.

Credit channel effects are not completely ignored by these models, but tend to be incorporated in an ad hoc manner as borrowing or cash flow constraints. For instance, in the Federal Reserve Board of Governors’ FRB/US model constraints are imposed to try to mimic the behaviour of credit-constrained households and firms. Additionally, the investment equation in the FRB/US model is augmented with cash flow influences (Brayton and Tinsley, 1996). Credit constraints are also a feature of the Reserve Bank of New Zealand’s macroeconomic model to some degree. In this model, the stock of household assets and the future path of labour income determine the sustainable, long-run flow of consumption. Some consumers, however, consume all their current period income and do not accumulate assets. This can be interpreted as a credit constraint where some individuals do not have access to credit markets and hence are unable to smooth consumption by borrowing against their future labour income (see Black, Cassino, Drew, Hansen, Hunt, Rose and Scott, 1997; Claus and Smith, 1999).

Dynamic general equilibrium models that formally account for an explicit role of credit market frictions in business cycle fluctuations have begun to be developed in the literature. In these models, monetary policy can have a significant impact on the real economy because of asymmetric information and agency costs. None of the models is complete. In particular, elements that are important in an open economy are still not being captured. Moreover, these models often do not explicitly account for the bank lending channel. Typically these models incorporate a financial accelerator mechanism.

Bernanke, Gertler and Gilchrist (1999) develop a dynamic general equilibrium model that incorporates a financial accelerator. The key mechanism in this model is the link between an external finance premium and the net worth of prospective borrowers. The external finance premium is the difference between the cost of funds raised externally and the opportunity costs of internal funds. An increase in entrepreneurs’ wealth or net worth lowers the external finance premium. A decline in net worth raises it.

The basic structure of the model is as follows. There are three agents in the economy: households, entrepreneurs, and retailers. Households work, consume, and save. Entrepreneurs produce output by hiring labour and using capital, which they purchased in the previous period. Acquisitions of capital are financed out of entrepreneurs’ net worth and by borrowing. Entrepreneurs’ net worth arises from two sources: profits accumulated from previous capital investment and entrepreneurs’ income from supplying labour. Entrepreneurs produce wholesale goods in competitive markets, and sell their output to retailers who are monopolistic competitors. Retailers buy goods from entrepreneurs, differentiate them (costlessly) and then re-sell these goods to households. The monopoly power of retailers allows modelling nominal rigidities in the economy; otherwise, retailers play no role.

Entrepreneurs’ net worth is an important determinant of their cost of external finance. An increase in net worth lowers the external finance premium of entrepreneurs leading to increased borrowing, and thus higher investment, spending and production. A decline in net worth has the opposite effects. The main source of variation in net worth is entrepreneurs’ equity, which in turn is sensitive to unexpected shifts in asset prices and unanticipated changes in the ex post return to capital.

The financial accelerator magnifies the impact of monetary policy on the real economy and smaller countercyclical movements in interest rates are therefore required to dampen output movements. The greater the extent to which monetary policy is able to stabilise output, the smaller is the effect of the financial accelerator in amplifying and propagating business cycle fluctuations.

Calibrated for the United States, the model is able to replicate observed cyclical movements in macroeconomic variables when allowing for price stickiness, decision lags in investment and limited access to credit for some entrepreneurs. Bernanke, Gertler and Gilchrist (1999) do not incorporate credit rationing in the sense of Stiglitz and Weiss (1981), where some borrowers simply do not receive loans, but assume that the price of capital can differ across entrepreneurs.

Kiyotaki and Moore (1997) develop a model with Stiglitz and Weiss type credit constraints. Credit constraints arise because lenders cannot force borrowers to repay their debts unless the debts are secured. Assets such as land, buildings and machinery serve as collateral for loans and borrowers’ credit limits are affected by the value of collateralised assets. The basic structure of their model is as follows. There are two goods, a durable asset (land) and a nondurable commodity (fruit) and two types of agent: farmers and gatherers. Both farmers and gatherers produce and eat fruit. In each period, land is exchanged for fruit at a given price, and fruit is exchanged for a claim to some fruit in the next period.

Farmers’ technology is idiosyncratic in the sense that, once their production has started at date with some land, then only they possess the skill necessary to cultivate the land to bear fruit at date . Moreover, it is assumed that farmers can always withdraw their labour. This implies that if farmers have a lot of debt, they may try to threaten their creditors by withdrawing their labour and repudiating their debt contract. Lenders protect themselves from the threat of repudiation by collateralising farmers’ land; that is, farmers must make a down payment in order to purchase land. At date farmers can borrow up to an amount at which the repayment does not exceed the (expected) market value of their land at date .

Gatherers’ production does not require any specific skills and gatherers, unlike farmers, are not credit constrained. Because gatherers are not credit constrained their demand for land is determined where the present value of the marginal product of land equals the opportunity cost of holding land. The amount of land is fixed, so if farmers’ demand for land increases, then in order for the land market to clear, gatherers’ demand has to decline.

The dynamic interaction between credit limits and asset prices is an important transmission mechanism by which the effects of shocks persist, amplify and propagate business cycle fluctuations. For example, a temporary productivity shock that reduces the net worth of credit constrained farmers forces farmers to cut back their demand for land. For the land market to clear, the demand for land by the gatherers has to increase, which requires that their opportunity costs of holding land must fall. The land price drops by the same amount as the opportunity costs of holding land, which lowers the value of farmers’ existing landholdings, and reduces their net worth still further. Small temporary productivity shocks thereby generate large and persistent fluctuations in output and asset prices. The fluctuations in output become even more persistent when capital (trees) is reproducible, i.e. investment is introduced, and when in each period only a fraction of the farmers are able to invest.

Carlstrom and Fuerst (1997) develop a general equilibrium model that explicitly incorporates financial intermediaries. There are three agents in this model: entrepreneurs, consumers and financial intermediaries (capital mutual funds). Entrepreneurs receive external financing from households through the capital mutual funds. The creation of new capital (including entrepreneurial capital) is subject to agency costs, which in turn are a function of entrepreneurs’ net worth. An increase in net worth lowers agency costs and thus lowers the cost of new capital. A decline in net worth increases agency costs and the cost of capital.

Calibrated for the United States, the model is able to replicate observed movements in output. Following a temporary positive productivity shock, for example, output rises gradually. This is because the shock causes households to delay their investment decisions until agency costs are at their lowest level – several periods after the initial shock. Agency costs fall over time because the shock increases the return to internal funds and net worth.[28]

Carlstrom and Fuerst show how agency costs arising from the difference between the costs of external and internal funds can alter business cycle dynamics following a supply-side shock. However, the model abstracts from demand-side shocks and does not explicitly model a monetary authority.

Edwards and Végh (1997) develop a theoretical model of a small open economy with privately-owned banks that allows for monetary policy shocks. They have four agents in the economy: households, entrepreneurs, banks and a government/monetary authority. Households are subject to a deposit-in-advance constraint and must use demand deposits to purchase consumption. Entrepreneurs produce output by hiring labour from households. They face a credit-in-advance constraint and must borrow from banks to pay households’ wages. Banks lend to entrepreneurs and hold households’ demand deposits. Banks finance their lending to entrepreneurs through deposits and borrowing internationally. Banks’ operations are costly, which introduces a wedge between the lending rate and the deposit rate, the interest spread. Changes in the interest spread and bank credit, resulting from shocks to the banking system and world business cycle, lead to fluctuations in output and employment.

Edwards and Végh (1997) explicitly model financial intermediaries and allow for a foreign sector. However, the theoretical model, which is not empirically tested, only incorporates the bank lending channel, although it appears that the bank lending channel by itself cannot explain the macroeconomic fluctuations that are observed following a monetary policy shock (Fisher, 1999). Moreover, the economy in the model does not operate under a flexible exchange rate and so does not provide information on interactions between financial intermediaries' actions and the exchange rate channel.

The models discussed in this section are important contributions to understanding the effects of imperfect information in credit markets. But each is incomplete and further work is needed. General equilibrium models of the credit channel, where agents’ decisions are derived from optimising behaviour, have mainly focused on the closed economy. The credit channel has yet to be incorporated in a model of an open economy with a floating exchange rate. Moreover, models to date generally only allow for either the bank lending channel or the balance sheet channel, but not both.

Notes

  • [28]Carlstrom and Fuerst (1997) assume that entrepreneurs are long-lived. In Fuerst (1995) entrepreneurs only live for a single period and the model is unable to replicate the positive serial correlation observed in output.
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