Bank lending, credit shocks, and the transmission of Canadian monetary policy

This paper uses a sticky-price dynamic general-equilibrium model to study the role of bank lending as a transmission mechanism of monetary policy shocks and to assess real effects of exogenous credit shocks under alternative monetary policy Taylor-type rules. Financial frictions, which are modeled as spreads between deposit and loan interest rates, depend on economic activity as well as on exogenous credit shocks. A general finding is that, even though almost all of the real effects of a monetary policy shock come from the price rigidity, imperfections in credit markets are responsible for their significant amplification. Nevertheless, if the central bank follows a forward-looking inflation targeting rule, bank lending is responsible for transmission of monetary policy shocks even though prices are flexible. Moreover, exogenous credit shocks account for substantial fractions of output, inflation, and nominal interest rates fluctuations in the short and medium terms.