The Impacts of Credit Standards on Aggregate Fluctuations in a Small Open Economy: The Role of Monetary Policy

Abstract

Empirical evidence demonstrates that credit standards, including lending margins and collateral requirements, move in a countercyclical direction. In this study, we construct a small open economy model with financial frictions to generate the countercyclical movement in credit standards. Our analysis demonstrates that countercyclical fluctuations in credit standards work as an amplifier of shocks to the economy. In particular, the existence of endogenous credit standards increases output volatility by 21%. We also suggest three alternative tools for policymakers to dampen the effects of endogenous credit standards on macroeconomic volatility. First, the introduction of credit growth to the monetary policy succeeds in counteracting the fluctuation of lending, and thus decreasing the additional volatility considerably. Second, the exchange rate augmented monetary policy, if well-constructed, is considered an efficient tool to eliminate most of the additional fluctuations caused by deep habits in the banking sector. Finally, the introduction of the foreign interest augmented policy also proves successful in dampening the effect of endogenous movements in lending standards.

Effect of Financial Frictions on Monetary Policy Conduct: A Comparative Analysis of DSGE Models with and without Financial Frictions

“…Conversely, in Tunisia, where the loan rate is indexed to the policy rate, the loan costs increase, impacting firms' net value. This mechanism, commonly referred to as the Fisher effect, exerts a detrimental influence on investment and real economic activities (Le 2021). Furthermore, we found that the bank's net worth decreased in response to monetary tightening.…”

“…This shock was calibrated such that it determined a decrease in bank capital of 5% on impact. In this exercise, we used the bank leverage ratio as proxy of the measure of financial frictions, whereby the more the ratio increased, the more banks took risks (Suh and Walker 2016;Li 2022;Le 2021). Three cases were considered: a high level of financial frictions, ∅ b t = 15%; an average level of financial frictions, ∅ b t = 8.9%; and a low level of financial frictions, ∅ b t = 3%.…”

The Effects of Monetary Policy on Macroeconomic Variables through Credit and Balance Sheet Channels: A Dynamic Stochastic General Equilibrium Approach

“…In other words, the experiences gained at first can be considered to be changes in the effectiveness of monetary policy, but the fact is that the lack of attention to non-neoclassical channels has led to this. Recent studies show that different countries have seen different results from the impact of policies and monetary shocks on the real sectors of the economy due to the different characteristics of banks and firms, and factors such as the balance sheet and financial health of banks play a different role in the impact of monetary policy [10,59,62,64,[97][98][99][100].…”