We consider a competitive bank loan market model where the marginal costs of managing and monitoring loans are assumed to increase as a borrower's net worth decreases. We show that the responsiveness of equilibrium bank loan rates to changes in interbank money market rates becomes weaker as a borrower's net worth decreases. In other words, monetary policy becomes less effective as a borrower's net worth decreases. We test and confirm this prediction by estimating bank loan rate equations using Japanese data. We find that the effectiveness of expansionary monetary policy in the 1990s has been significantly weakened by the deterioration of borrowers' balance sheets, contributing to the long stagnation of the Japanese economy during the period.
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Paper provided by Institute of Economic Research, Hitotsubashi University in its series Discussion Paper Series with number
a388.