Real Rigidities in the Credit Market
How imperfections in the goods markets enable firms to set prices so as to generate price rigidities, e.g., because of countercyclical mark-ups used in setting the prices oligopolistically. You know that such price rigidities have macroeconomic consequences, e.g., changes in aggregate demand influence output and employment rather than prices. Imperfections in the credit market too similarly have macroeconomic consequences. The imperfections in the credit market which have macroeconomic consequences are broadly classified as rigidities in the credit market. In this sub-section we examine some of the macroeconomic consequences of these credit-market rigidities.
Imperfections arise in the credit market primarily because of asymmetric information between lenders and borrowers. Borrowers are better informed than -the lenders about the quality of their investment projects and even the probability of success of the projects. It has been shown that these type of information asymmetries can have important microeconomic consequences like equilibrium credit rationing, need for financial intermediation, and need for government intervention.
But, more importantly for us, credit market imperfections such as information asymmetries have macroeconomic consequences. It has been shown that in the monetary policy transmission mechanism
i) credit channel is more important than money supply channel, and
ii) credit-rationing is more important than rise in interest rate in the implementation of a restrictive monetary policy.
Thus when a restrictive monetary policy reduces reserve money, i.e., the quantity of bank reserves, the ability of the banks to lend is affected. The shortfall in credit is not necessarily made up by other lenders, given the imperfections in the credit market in the form of information asymmetries between lenders and borrowers. Banks are actually in a better position than many of the other lenders to overcome the adverse effects of information asymmetries through their role of a financial intermediary. Thus, the transmission mechanism operates largely through availability of loans. The process of credit rationing that takes place when loans are curtailed become more important in reducing aggregate demand than the process initiated by an increase in the rate of interest through the reduction of money supply.
Given this importance of credit markets, credit-market imperfections can propagate and magnify the effects of real disturbances. Shocks that act initially to reduce output or to redistribute wealth from borrowers to lenders cause credit markets to function less efficiency which leads to a further decline in output through the credit channel. It has been shown that disturbances that would have mild effects with Walrasian credit markets (e.g., with no asymmetries of information between lenders and borrowers) can cause a financial collapse in the presence of such imperfections because of the magnification effects.