Financial Frictions and the Credit Channel of Monetary Transmission

This paper examines the effect of financial frictions on the strength of the credit channel of monetary transmission. We first use a DSGE model characterized by financial frictions as in Bernanke, Gertler, and Gilchrist (1999), and calibrate it using parameter values for countries with different levels of financial frictions. We find that the credit channel is stronger in countries with high levels of financial frictions. The intuition is that in these countries, external finance premiums are more sensitive to firms’ financial leverage. By affecting asset prices and borrower leverage, therefore, monetary policy has greater impact on external finance premiums and output. We then test this model’s result by estimating SVAR models on cross-country data to generate indicators for the strength of the credit channel of monetary transmission. We find a positive relationship between various measures of financial frictions and the strength of the credit channel, confirming the predictions of the model.