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The Effect of Monetary Policy on Credit Spreads

Capital market theories based on the credit view of monetary policy predict that a monetary policy shock would have a stronger impact on firms with limited access to capital markets. The exact transmission mechanism depends on the assumptions of the specific model. Models based on the balance sheet channel of monetary policy (e.g. Bernanke and Gertler (1989), Kiyotaki and Moore (1997)) argue that a firm’s balance sheet serves as a collateral in financial markets with information asymmetry between borrowers and lenders.

A firm with a weak balance sheet would have limited access to capital markets and would thus be more sensitive to monetary policy shocks. On the other hand, models based on the bank lending channel (e.g. Bernanke and Blinder (1992), Kashyap et al. (1993)) argue that firms with limited access to capital markets might be more bank-dependent. Since banks adjust their supply of credit with changing credit market conditions, these firms with limited access to capital markets would be more sensitive to monetary policy shocks.

Whether through the balance sheet or the bank lending channel, these models predict that firms with limited access to capital markets would not only be more sensitive to monetary policy shocks but also this effect would be more pronounced during bad times when both economic and credit market conditions deteriorate. Models based on the balance sheet channel argue that firms with weak balance sheets would become even more distressed during bad times due to decrease in demand for their services or products.

Hence, these firms would find it even harder to have access to capital markets and would become even more sensitive to changes in monetary policy during bad times. On the other hand, models based on the bank lending channel argue that banks might be unwilling or unable to supply as much credit during bad times. Firms with limited access to capital markets that are more bank-dependent would become even more sensitive to changes in banks’ supply of credit which in turn depends on monetary policy.

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The Effect of Monetary Policy on Credit Spreads