Q) Explain them monetary transmission mechanism which are based on asymmetric information. Explain their operational effectiveness in normal economic times in the United States and in the United Kingdom. Were these channels operationally effective during the financial crisis of 2008?
(Before you start writing you should understand the bank lending channel, bank capital channel and the balance sheet channel.
Try to understand how they work during normal times – read the lecture note and the papers provided in the class. )
During the crisis period Fed and BoE took expansionary policy, so monetary policy rate was low. If bank lending channel (BLC) operated then banks would give more loans and output would increase. But in reality it did not happen. Before the crisis most of the banks in UK and US dependent on short term funds from the money market and on securitization for funding and less on insured deposits. Thus during the financial crisis when asset prices and house prices went down and there was high uncertainty in the money market banks did not lend to each other so banks could not get funds to generate loans. Thus even though central banks took expansionary policy commercial banks did not increase loans. The reasons might be due to
1) During the financial crisis when asset prices and house prices went down and there was high uncertainty in the money market banks did not lend to each other so banks could not get funds to generate loans.
2) High uncertainty between the borrower and the lender.
You can measure uncertainty in the money market by looking at the difference between
Libor rate – monetary policy rate. The difference between the two is the risk premium.
If uncertainty is high this difference will be high. If the BLC worked properly then the difference/risk premium should be low and banks cost of getting funds will be low. But in reality during the crisis premium was high , so banks had to pay extra money to get their funding. So lending might have decreased.
Looking at the balance sheet channel (BSC) it did not work properly. Because of the crisis firm and individuals financial net worth went down (because house price went down andbecause stock prices went down). This made them financially more distressed, So if they wanted a bank loan banks would charge them more for the loan because now more uncertainty is involved. You can measure this by looking at the difference between the lending rate/mortgage rate-monetary policy rate. If the channel worked properly it would have gone down because and people and firms would get more loans and output would increase.
You can get these data from Fed and BoE and IFS websites or Datastream
(the links are in the module handbook)
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