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Do you know how changes in interest rates affect the consumption decisions of businesses and households?
The impact of central bank monetary policy decisions on the economy is ubiquitous, especially by affecting the availability of credit and changing the consumption behavior of businesses and households. Through the transmission mechanism, these policy adjustments will affect purchasing decisions and cause economic fluctuations in the long term. While traditional monetary policy transmission mechanisms focus on how adjustments in short-term interest rates affect the cost of capital, the credit channel provides another perspective, emphasizing how credit availability further amplifies these effects.
The credit channel is an indirect amplification mechanism that affects economic activity by changing the amount of credit available in the economy.
Comparison of credit channels and traditional monetary policy
Traditional monetary policy transmission mechanisms, such as the interest rate channel, mainly focus on how the central bank affects the cost of capital by adjusting nominal and short-term interest rates, thereby affecting the consumption of durable goods and corporate investment. The credit channel, however, focuses on how policy changes affect the credit available to businesses and households, emphasizing the importance of this impact for the real economy. Tighter policy may lead to reduced availability of credit, thereby dampening consumption and investment.
The operating mechanism of credit channels
The operation of credit channels can be analyzed from several aspects. First, when short-term interest rates change, changes in external financing premiums further affect borrowing costs. The external financing premium refers to the cost difference between obtaining funds internally and raising funds from the market. Usually, the cost of external financing will be higher than that of internal financing. This reality will exist with the incomplete mortgage of the credit market, which will affect the availability of credit.
The size of the external financing premium depends on market frictions, such as imperfect information or contract enforcement costs.
The impact of balance sheet channels
The theory of the balance sheet channel holds that there is an inverse relationship between the borrower's net assets and the size of the external financing premium. Borrowers with higher net worth are more likely to rely on self-financing. These borrowers are less risky and therefore have lower loan costs. Therefore, when interest rates rise, the burden on borrowers increases, which may limit their demand for resources, thereby affecting spending and investment decisions.
The role of bank loan channels
The bank loan channel explains how monetary policy adjustments directly affect banks’ loan supply. When central banks adjust policies, banks' ability to obtain funding will be affected, which will further limit the ability of businesses and households to obtain credit through banks. In some cases, businesses may face lockdowns and must find alternative sources of financing, which in turn increases external financing premiums and reduces economic activity.
The liquidity constraints caused by zero deposits that cannot be easily replaced will affect banks' lending capabilities.
Empirical evidence and challenges
Some research shows that the credit channel can explain some peculiar phenomena of economic response after changes in monetary policy. For example, in specific economic scenarios, large-scale interest rate adjustments fail to immediately affect major consumer categories. This means that the credit channel has the ability to amplify the transmission mechanism, so that even a small change in interest rates can trigger a significant economic response in the credit market. In particular, small businesses under financial pressure often respond to capital shortages by reducing production and employment, while large companies may resort to short-term borrowing to maintain operations.
To sum up, whether it is from the downward pressure on the balance sheet of the credit channel or from the function of the bank loan channel, it can be seen that the interest rate decision-making of the central bank not only affects the cost of investment and consumption, but also directly affects the cost of credit. Availability. These impacts will ultimately have far-reaching consequences for the overall economy. How will businesses and households adjust their consumption and investment decisions in the face of economic fluctuations?
