Mechanisms of monetary transmission – interest rate channel

Financial factors play an important role in ensuring economic development. For instance, innovative ideas, expansion plans and recruitment of human resources and requisite technology for such expansion plans require financial resources for their timely execution. When such financing is provided by organically generated funds such as reserves (savings) then the financial sector involvement is minimal – providing deposit functions. In real business environment however entities and individuals cannot in most cases provide adequate financial resources to satisfy those demanded by the innovative ideas or expansion plans without compromising existing operations. The deficit to fund such ventures thus would be sourced from financing alternatives such as bank loans and venture capital (Bernanke, 2007, June 15).  The effect of monetary policy interventions on the lending power of institution thus could affect businesses’ ability to secure funding. The ways through which the monetary policy affects such aspects as banks’ ability to issue credit facilities to firms ensuring success of the latter’s expansion programs leading to real economic effects may vary.

The first view advanced to lead into real economic impacts following monetary policy approaches can be explained through interest rate channel a view advanced in traditional Keynesian economic theory. According to this model, as Ireland (2005) advances, short-term policy induced increases in nominal interest result into long-run nominal interest rates due to investor actions to reduce differences in “risk-adjusted expected returns on debt instruments” (p.4). Failure by nominal prices to rapidly adapt to the changes implies that the nominal interest rates result into changes in the real interest rates thus resulting into increased cost of borrowing for firms leading to their scaling back of operations. Amplification of this effect is generated when individuals also scale back their expenditure on durable goods such as automobiles (Ireland, 2005). In the oil industry this effect could prevent firms from acquiring credit facilities based on their assessment of how these would factor into the cost of capital. Ramirez (2004) identifies this as the standard money channel that central banks’ policies such as open-market operations, that result into alterations of real interest rates and hence changes in cost of capital employ to result into real variable effects in the economy such as changing production and employment level. For instance, increased effective interest rates on loans would deter oil companies that wish to fund their expansion into markets other than their traditional market, if such expansion plans were reliant on availability of cheap external funding sources. In recent times the finding of oil deposit and exploration activities taking place in some countries that have necessitated huge capital investment makes for examples of why the oil industry would require funds than cannot be adequately provided by the savings (reserves) from operating activities. The cost of capital – though a traditional approach – could thus influence the level of development projects that an entity is willing to undertake thus an arguable way through which monetary policies impacts on the oil industry’s real economic variables.

In addition to the cost of capital model of transmission and as Bernanke (2007, June 15) points out, the credit channel also allows for the monetary policy approaches to be reflected in the real indicators of the economic situation. Through the balance-sheet approach and/ or the bank lending approach, the credit channel theory proposes that interest rate decisions do not only affect the lending process through altering the cost of capital; but that such would also, in part, impact on the potential borrowers’ assets and cash flows’ values thus determining their creditworthiness – the balance sheet model (Bernanke, 2007, June 15). Due to imperfect information that has resulted from previous financial shocks such as the 1930s depression, availability and the cost of external funding from financial intermediaries is advanced to rely on factors influencing the strength of an organization’s balance sheet (Mateut, Bougheas & Mizen, 2006). Companies that exhibit a weak balance sheet position would thus not get access to financial services hence limiting the extent of development projects that they can undertake. The implication of the balance sheet model as an agent of the monetary policy is buttressed in presence of imperfections in the financial markets in that the cost of credit to a firm from an external source (bank or otherwise) increases with the decrease in the financial position exhibited by the balance sheet (Bernanke and Gertler,1995). Substantial funding to oil corporations thus would be pegged on their balance sheet credibility hence excluding some of potential borrowers who could sustain aspects such as employment level by expanding their operations. go to credit channel of monetary transmission.

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