Working Paper no. 166
By Simon Hall and Anne Vila Wetherilt
This paper uses the popular Bernanke, Gertler and Gilchrist (BGG) model to explore links between the financial health of the non-financial corporate sector and bank lending behaviour on the one hand, and the effectiveness of monetary policy on the other. We use the model’s microeconomic contracting framework to generate specific financial scenarios, defined in terms of steady-state credit spreads, bank lending policies and corporate sector financial health. We embed these scenarios in the macroeconomic BGG model and investigate how they affect dynamic responses of the real economy to monetary and real shocks. Our simulations show that in the context of the BGG model, the balance sheet positions of the financial and non-financial corporate sectors can affect the monetary transmission mechanism. We illustrate that in certain financial scenarios in the model the financial accelerator mechanism is very potent, whereas in others it has little incremental impact. This implies that, for a given shock, monetary policy can be less or more proactive, respectively. In addition, the model simulation results suggest that certain parameters may merit particular attention. For example, the sensitivity of bank lending policy to news about corporate financial health has an especially marked impact in the model’s dynamics. And as illustrated in previous work, corporate leverage also plays an important role in amplifying and propagating shocks.