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Search, Financial Market Frictions, and Monetary Transmission

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  • VICTOR E. LI

Abstract

This paper evaluates the implications of search and matching frictions in the financial market for the bank lending channel of monetary policy. Borrowers and lenders participate in a decentralized loan market for the purpose of establishing long‐term credit relationships and the provision of loanable funds to productive firms. Locating credit relationships is costly in terms of time and real resources and the interest rate is negotiated via a bargaining mechanism. This structure is incorporated into an otherwise standard monetary business cycle framework and used to study how such frictions in the credit market contribute to explaining the contemporaneous impact and propagation of monetary growth shocks and inflation. While anticipated inflation negatively impacts real activity, it can also increase loan market participation and the inflow of newly established credit relationships. It is shown that (i) bargaining and costly search mitigates the traditional inflation tax effect of monetary injections and (ii) the existence of long‐term lending relations tends to dampen liquidity effects. Monetary shocks in this environment lead to larger liquidity effects relative to the frictionless case and are capable of generating persistence in the nominal interest rate, labor, consumption, and output. It can also explain the excess volatility of credit creation relative to output and the observation that overall credit creation can lead output over the business cycle.

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  • Victor E. Li, 2018. "Search, Financial Market Frictions, and Monetary Transmission," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 50(8), pages 1935-1968, December.
    • Handle: RePEc:wly:jmoncb:v:50:y:2018:i:8:p:1935-1968
    DOI: 10.1111/jmcb.12571
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