Changes in the real interest rate influence firm investment and household spending decisions on durable goods.
These changes in investment and durable good purchases affect the level of aggregate demand and final production.
Source:[2] The credit channel view posits that monetary policy adjustments that affect the short-term interest rate are amplified by endogenous changes in the external finance premium.
Fully collateralized financing implies that even under the worst-case scenario the expected payoff of the project is at least sufficient to guarantee full loan repayment.
The size of the external finance premium that results from these market frictions may be affected by monetary policy actions.
The bank lending channel refers to the idea that changes in monetary policy may affect the supply of loans disbursed by depository institutions.
The balance sheet channel theorizes that the size of the external finance premium should be inversely related to the borrower's net worth.
A basic model of the financial accelerator suggests that a firm's spending on a variable input cannot exceed the sum of gross cash flows and net discounted value of assets.
[8] An increase in interest rates will tighten this constraint when it is binding; the firm's ability to purchase inputs will be reduced.
Consumers who hold more liquid financial assets such as cash, stocks, or bonds can more easily cope with a negative shock to their income.
[9] Banks serve to overcome informational problems in credit markets by acting as a screening agent for determining credit-worthiness.
For example, Bernanke and Gertler (1995) [2] describe 3 puzzles in the data: Since the credit channel operates as an amplification mechanism alongside the interest rate effect, small monetary policy changes can have large effects if the credit channel theory holds.
Asset price boom and bust patterns in the 1980s may have led to the subsequent real fluctuations observed in many advanced economies.
Banks who lend heavily in sub-prime communities will face higher external finance premiums because the risk from holding assets composed largely of subprime borrowers is relatively high.