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.