Introduction
Monetary policy is believed to be a powerful tool in dealing with inflation problem. Based on Mishkin (1995), tight monetary policy that published by the Federal Reserve can solve the problem of inflation, but at the same time can bring the economy to the recession problem. Because such a massive impact may occur, therefore if the authorities want to make decisions relating to monetary policy, it must be prepared utterly inconceivable is the time and the impacts that occur as a result of the decision. It should be noted that monetary policy can be successful and have a positive impact on the economy.
There are some traditional channels in the transformation of monetary policy, such as the interest rate channel, the exchange rate channel, and other asset price effect. Every single channel has different component and different impact to the outcome.
Besides those monetary policy transformation channel, we also know the credit channel, there are some examples of credit channels, such as bank lending channel and balance sheet channel.
In this paper, we will look further on the interest rate channel and bank lending channel. This kind of channel is created because there is a dissatisfaction with the conventional channels, which only figure out how the interest rate changes have impact on the long term asset. This new method includes how asymmetric information and agency cost in the financial market, which also have contribution or impact to the economy.
Interest Rate Channels
Firstly, we will look further in the interest rate channels. This is the popular model, which known as Keynesian Model. In this model there are four components that have influence of one component to another. The model can be explained by the following figure.
Figure 1. Interest Rate Channel
In Figure 1, we can see that the components of interest rate channel are money supply, cost of capital, investment, and aggregate demand or output. The tight money policy will give impact to all of the component that involve in this channel.
It can be seen that because of the tight money policy makes the money supply is decreased, this limitation to the supply of the money in the market makes the interest rates increases. Interest rates increased due to the law of supply and demand. The amount of money circulating in the market less than requested by the market, resulting in a spike in market interest rates. The increase of the interest rates in the market may impact to the company's cost of capital. The cost of capital of a firm will increase, because the interest rates of bank loans rise. Rising lending rate or cost of capital of the company will result in the decrease of the investment made by the company because a loan from a bank is one of the source of funds or capital for the companies to do investment, for example, a firm would build less plant or factory than before because of the impact of the increase in cost of capital. Investment has a positive relation with the output that the company will produce. It means that less investment has an impact to less product or output that can be produced by the company. Investment in this channel is not only in the procurement of the plant by the company, but also from the perspective of households, investment here is related to residential housing, in the other world investment in housing.
Based on the explanation above, we can see that tightening the money supply can bring those kind of impact to the economy. In general, tightening the money supply will make the interest rate increases and will reduce the output, because the cost of capital to produce the output become more expensive than before. This impact makes a deceleration of the economy. We can summarize that it can be seen that the presence of a strong effect caused by the interest rate to the consumer and investment spending.
Bank Lending Channel
The other channel that we will discuss in this paper is called bank lending channel. The bank lending channel depends on the perspective that banks assume a unique part in the monetary framework since they are particularly appropriate to manage certain sorts of borrowers, particularly small firms where asymmetric information issues can be particularly professed. All things considered, extensive firms can specifically get to the credit markets through stock and security markets without experiencing banks. Accordingly, a contractionary money related arrangement that declines bank reserves and deposit will have an effect through its impact on these consumers. We can summarize the scheme of this channel in the figure below.
Figure 2. Bank Lending Channel
In Figure 2, we can see that the output is still affected by the investment. But there is a difference between the bank lending channel with the interest rate channel. The difference is the component in this channel. As we can see from the figure, the money supply will impact on the bank deposit, bank reserve, supply of bank loans, investment, and finally the output will be also affected by the decrease of the money supply.
In this channel, the decrease in money supply affect the amount of bank deposit. The bank deposit will decrease as the impact of the decrease in money supply. This happens because there is a supply and demand law. The amount of money in the market is less than the money that demanded by consumers. Because of that people prefer not to deposit the money, but they use the money for other purpose. The reduce of consumers’ saving or deposit will affect to the decrease of bank reserve, because to calculate the bank reserve, it is calculated from the deposits. Normally a bank has 5% reserve from their deposit. This reserve is needed by the bank to ensure that there is some amount of money when the bank is needed to give to the depositor when they want to withdraw their money from the bank. As we know bank deposits is one of the the source of fund for the bank to lend money to other customers. With the decrease of the bank deposits means that the supply of bank loans will also decrease. The decrease of the supply of the bank loans makes the investment also decrease. This happens because investment normally finance by loans from the banks. The impact of the decrease of supply of bank loans makes the investment will decrease. Because of the positive relation between investment and output, the decrease of investment makes output also decrease because the development of facilities, such as plant of factories is decrease because the difficulties in finding loans for financing that.
This channel is very influential, especially for small companies, because of the small enterprise funding sources usually come from the bank. This is because small companies are difficult to obtain external sources of financing, such as issuing bonds or shares. Costs incurred to issue shares or bonds is expensive, so it is not possible for the companies that categorized to the group of small companies. Therefore, small companies depend heavily on banks, because the banks are the only source of funds to make investments, outside funding from within the company, such as the increasing capital from the owner of the firm. If banks cut back on lending, the smaller companies are also subject to impact.
In contrast to small companies, large companies are also affected by this channel, but the impact is not as big as that experienced by small companies. This occurs because the source of funding large companies does not only depend on loans from banks. Large company may issue bonds or shares to finance the company's project. The issuance of bonds and stocks will be easier for large companies compared with small companies.
Critics on Interest Rate Channel
Based on Bernanke & Gertler (1995), found in some previous studies that the components contained in the interest rate channel is difficult to describe quantitatively important effect on the neoclassical variable cost of capital. In the journal also said that a lot of discoveries about non neo classical factors such as sales or cash flow is influenced spending. According to the explanation above, it can be concluded that the components contained in the interest rate channel is not fully explain what is going to impact on spending, there are factors outside that counts in the channel that also affect spending significantly.
Besides those, in the journal of Bernanke & Gertler (1995) also found also found that factors in the interest rate channel should be expected to have a considerable influence on short-term interest rates and weaker influence in the long term interest rate. Although some journals should explain as expected, but in fact that the monetary policy has the greater impact on long-term assets. For example, long term asset in question is a housing loan. Loans like this are very sensitive to changes in interest rates. Many of the risks posed are attributable to changes in interest rates on these assets.
A gap in the interest rate channel makes economists started realizing there is asymmetric information in the market. The existence of imperfect information makes the emergence of the credit channel that captures the phenomena. There are two channels which is related to the credit channel, there are balance sheet channel and bank lending channel. Bank lending channel focuses on the supply of loans that the bank provided that affect the output of the firm.
Summary
Based on the above explanation, it can be concluded that both channels, interest rate channel and the bank lending channel, have different components, but the channel is affected due to changes in monetary policy by the policy makers. Normally the effect to the tightening the money policy.
The interest rate channel focus on the interest rate changes as the impact to the changes in the money supply. Interest rate changes will impact to the decrease of the output that the company can produce. On the other hand, bank lending channel focus on the supply of the loans that the bank provided to the customer as the impact of the tightening the money supply in the market. Both channels have the impact to the decrease of the output as a result of the decrease in the money supply.
Many previous research said that there is the weakness in the interest rate channel. This channel only focus on the interest rate that influenced the aggregate demand, whereas there are several factors beyond the interest rate also affects aggregate demand that is not included into these channel components. In addition, the channel's creators consider this channel more influence short-term interest rates, compared to the long term. In fact, the long-term assets are more sensitive to changes in interest rates than short-term assets. Thus some of the explanations above, the interest rate channel has some weaknesses.
Given some of the information asymmetry, credit channel is believed to be able to capture the phenomenon. In other words, things that can not be captured by the interest rate channel can be captured by this channel credit. Bank lending channel focused on bank lending decreased supply resulting decline in output due to reduced availability of funding is a loan from a bank. Bank lending channel is more influential to small firms compared with large companies. This happens because the small company relies heavily on bank loans for their funding sources.
To sum up, some weakness in the interest rate channel, that some factors are not taken into account in this channel can be addressed by some of the components are taken into account in the credit channel, especially the balance sheet channel and bank lending channel.