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October 25, 2005
A couple of papers by Bernanke and Gertler (and why I think they are important)
Mark Thoma (Economist's View) links to a paper by Bernanke and Blinder in this post. The paper is about the credit channel for monetary policy, a topic that Bernanke would revisit a few more times, including this paper (joint with Mark Gertler) in the Journal of Economic Persectives titled "Inside the Black Box: The Credit Channel of Monetary Policy Transmission" (JSTOR link--subscription required).
Also important is this paper in the American Economic Review titled "Agency Costs, Net Worth, and Business Fluctuations." Quoting from the introduction:
First, since borrower net worth is likely to be procyclical..., there will be a decline in agency costs in booms and a rise in recessions. We will show that this is sufficient to introduce investment fluctuations and cyclical persistence into an environment which is rigged to exhibit neither of these features when agency costs are not present; a kind of accelerator effect emerges. Second, shocks to borrower net worth which occur independently of aggregate output will be an intitiating source of real fluctuations. A possible example of this is "debt-deflation," first analyzed by Irving Fisher (1933): During a debt-deflation, because of an unanticipated fall in the price level (or, alternatively, a fall in the relative price of borrowers' collateral, for example, farmland), there is a decline in borrower net worth. This has the effect of making those individuals in the economy with the most direct access to investment projects suddenly un-creditworthy.... The resulting fall in investment has negative effects on both aggregate demand and aggregate supply.
At the root of the problem is the information asymmetry between the borrowers and lenders which gives rise to agency costs. Bernanke and Gertler find that this specific friction can have balance sheet implications which give rise to real fluctuations. It is another example of the credit channel, but a very specific one. It highlights one of the reasons that deflation (or a fall in the value of collateral) is such an important problem. Deflation has balance sheet implications, and with information frictions (agency costs), there is a real effect on output. This kind of research linking the financial and the real sector is present in much of Bernanke's work.
If we are to make progress on the current puzzles confronting policymakers, a good framework for thinking about the linkage between the real sector and the financial sector is vital. One of the Fed's most important roles is as lender of last resort. The are a provider of liquidity in time of crisis, whether that crisis takes the form of a terrorist attack across the street or a currency collapse across the globe. Understanding seemingly esoteric subjects like the transmission mechanism has important implications for the way the Fed thinks about the real consequences of balance sheet problems.
Posted by William Polley at October 25, 2005 4:26 PM
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