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How financial markets affect the real economy- and how monetary policy should react

  • Published Date: September 2013

HOW FINANCIAL MARKETS AFFECT THE REAL ECONOMY – AND HOW MONETARY POLICY SHOULD REACT: New analysis by ECB economists

An adverse shock to financial markets that increases banks’ lending spreads warrants a decisive easing of monetary policy, very much along the lines of the large and rapid interest rate cuts implemented at the peak of the 2007-09 financial crisis.

That is one of the main findings of research by Fiorella De Fiore and Oreste Tristani, two economists at the European Central Bank (ECB). Their study, published in the September 2013 issue of the Economic Journal, uses a model that recognises the importance of credit markets and lending spreads as determinants of economic activity.

The analysis captures some key stylised features of lending relations:

· First, firms need external finance, which they obtain from banks.

· Second, the interaction between banks and firms is characterised by ‘asymmetric information’. Banks therefore charge higher lending spreads when firms are riskier – that is, when they have higher leverage.

The researchers use the model to address two key normative questions:

· Should financial market conditions matter per se for policy – or should they only be taken into account to the extent that they affect output and inflation?

· Does an increase in credit spreads of the magnitude observed at the peak of the 2007-09 financial crisis warrant a decisive easing of the monetary policy stance?

The answer to the first question is that financial market conditions matter both for their repercussions for the wider economy and on their own account:

· On the one hand, higher credit spreads lead to an increase in lending rates and thus in the marginal cost of credit for firms. This increase is passed on to final prices and, as a result, it reduces demand and depresses output.

· On the other hand, a higher volatility of credit spreads is also undesirable on its own account because it produces an arbitrary redistribution of resources between lenders and borrowers.

The answer to the second question is that in reaction to a negative financial shock that leads to a sizeable increase in credit spreads – as experienced during the 2007-09 financial crisis – a sharp cut in policy interest rates is warranted.

The policy easing offsets the increase in mark-ups that firms implement to cope with the higher cost of credit and prevents a sharper fall in consumption and aggregate demand.

ENDS


Notes for editors: ‘Optimal Monetary Policy in a Model of the Credit Channel’ by Fiorella De Fiore and Oreste Tristani is published in the September 2013 issue of the Economic Journal.

Fiorella De Fiore is currently Adviser in the Financial Research Division of the Directorate General Research at the European Central Bank in Frankfurt.

Oreste Tristani is currently Senior Adviser in the Directorate General Research at the European Central Bank in Frankfurt.

For further information: contact Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com; Twitter: @econromesh); or Oreste Tristani via email: Oreste.Tristani@ecb.int