DP2892 Corporate Finance and the Monetary Transmission Mechanism

Author(s): Patrick Bolton, Xavier Freixas
Publication Date: July 2001
Keyword(s): corporate finance, equity capital adequacy constraints, monetary policy
JEL(s): E51, G30
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2892

This Paper analyses the transmission mechanisms of monetary policy in a general equilibrium model of securities markets and banking with asymmetric information. Banks' optimal asset/liability policy is such that in equilibrium capital adequacy constraints are always binding. Asymmetric information about banks' net worth adds a cost to outside equity capital, which limits the extent to which banks can relax their capital constraint. In this context monetary policy does not affect bank lending through changes in bank liquidity. Rather, it has the effect of changing the aggregate composition of financing by firms. The model also produces multiple equilibria, one of which displays all the features of a ?credit crunch?. Thus, monetary policy can also have large effects when it induces a shift between equilibria.