Collateral Channel – Financial Accelerator and Monetary Policy Transmission Mechanism

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School of Business | Master's thesis
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Degree programme
In this paper, I explore how asymmetric information in financial markets cause amplification of economic shocks and monetary policy transmission through a dynamic mechanism called the collateral channel. I do this by reviewing and summarizing modern theoretical research. I also assess results of empirical studies to report the relevancy of the collateral channel theory. In addition, I overview Finnish and Japanese financial crises in 1980s and 1990s that are characterized with high private credit accumulation and plummeting asset prices during the boom and bust periods to find out what was the role of collateral channel dynamics in these crises. The theoretical studies assessed in this thesis suggest that the assumption of perfect financial markets in macroeconomic models leads to faulty modeling of dynamics affecting the real economy. In the presence of financial market frictions, firms use collateral to acquire loans for production investments. This may cause collateral channel dynamics when economic shocks or monetary policy change firms’ net worth increasing or decreasing the cost of external finance, leading to changes in investment possibilities. In many cases, the empirical evidence on the collateral channel is prominent when the investment- net worth sensitivities are proven to be statistically significant. Monetary policy actions are also seen to affect the economies significantly through the collateral channel. Certain characteristics of firms are seen to make them more vulnerable for these sensitivities (size, tangibility of assets and banking relationships). Moreover, the monetary policy aspect of collateral channel is clearer when searching evidence form historical financial crises. The experiences of Finland and Japan during financial crises show how that collateral channel dynamics are strongly present when monetary policy actions lead to real crises in the economies with a heavily indebted private sector.
Thesis advisor
Terviö, Marko
asymmetric information, credit constraint, collateral channel, monetary policy
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