The Credit Channel in a Small, Open Economy

Abstract

Financial market imperfections - particularly finance constraints - play an important role in modern corporate finance, but relatively little work has been done on the interaction between corporate finance and the broad operation of financial markets. In particular, relatively little has been done on the interaction between corporate finance and monetary policy. In an influential paper, Chevalier and Scharfstein (1996) argue that financial market imperfections can lead to a link between markups and business-cycle fluctuations. The key idea is that financial market imperfections imply that the markup will be more countercyclical. Under imperfect competition, firms face a tradeoff between increasing market share (by keeping prices low today) and earning monopoly profits in the future - or charging higher prices today to boost current profits. Market share is a form of investment, so the optimal tradeoff depends on the discount rate. Finance constrained firms will face a higher shadow discount rate and will therefore reduce investment in market share. A negative shock, such as monetary policy tightening, implies that finance constraints bind more tightly. This implies that constrained firms will charge higher prices (for given marginal cost). In other words, markups will rise for these firms. If the Chevalier-Scharfstein model is correct, contractionary monetary policy should have different implications for the price paths of firms, depending on the extent to which they are affected by financial market imperfections. A contractionary monetary policy shock will cause the balance sheets of financially dependent firms to deteriorate and will cause the supply curves for various types of credit to shift to the left, increasing the shadow discount rate and inducing these firms to increase their markups, implying that their prices will be higher than they would be in the absence of financial market imperfections. This is a potential explanation for macroeconomic price stickiness that is different in character from the standard explanations, such as menu costs or sticky information. We find evidence consistent with the Chevalier-Scharfstein model. In addition, we use the Rajan-Zingales measure of financial dependence to examine other aspects of the response of financially dependent firms to monetary policy.