David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

19. 7 The transmission mechanism
Hence a change in interest rates has a larger effect the longer the life of the capital good. The investment
demand schedule is flatter, and the monetary transmission mechanism more powerful, for long-lived
houses and factories than for short-term machinery.7 A change in interest rates has more effect on longterm
projects.
Inventory investment
There are three reasons why firms desire stocks of raw materials, partly finished goods and finished goods
awaiting sale. First, the firm may be betting on price changes. Sometimes, firms hold large stocks of oil,
believing it cheaper to buy now rather than later. Similarly, firms may hold finished goods off the market
hoping to get a better price later.
Second, many production processes take time. A ship cannot be built in a month, or even a year. Some
stocks are simply the throughput of inputs on their way to becoming outputs.
Third, stocks help smooth costly adjustments in output. If output demand rises suddenly, plant capacity
cannot be changed overnight. A firm has to pay big overtime payments to meet the upsurge in orders. It is
cheaper to carry some stocks, available to meet a sudden rise in demand. Similarly, in a temporary
downturn, it is cheaper to maintain output and pile up stocks of unsold goods than to incur expensive
redundancy payments to cut the workforce and reduce production.
The credit channel of monetary policy
II
Recent research emphasizes that interest rates are not the only channel through which monetary
policy affects consumption and investment, and hence aggregate demand.
The credit channel affects the value of collateral for loans, and thus the supply of credit.
A lender usually asks for collateral - assets available for sale if you fail to repay the loan. Collateral is how
lenders cope with moral hazard and adverse selection: borrowers who know more about their ability and
willingness to repay than lenders know.
Suppose the price of goods falls, raising the real value of nominal assets. People have more collateral to offer
lenders, who thus lend more than before at any particular interest rate. The supply of credit rises and aggregate
demand for goods increases.
There are really two credit channels, since there are two reasons for changes in the value of collateral. First,
changes in goods prices change the real value of nominal assets. Second, and quite distinct, when monetary
policy changes the interest rate, this affects the present value of future income from assets and hence the
market value of collateral assets themselves.
This theoretical reasoning is supported by evidence from the natural experiment that we have called
quantitative easing. The purpose of quantitative easing was not simply to raise the broad money supply to
support the desired low level of interest rates. It was also believed that credit rationing by lenders was curtailing
private spending and reducing equilibrium asset prices, from houses to the stock market. Injecting more
money provided additional liquidity to people who would otherwise have been credit rationed, and the
consequent spending helped bid up house prices and share prices on the stock market. In turn, this improved
private sector collateral and made banks more willing to lend, causing a second-round beneficial effect.
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7 Equivalently, a 1 per cent rise in the interest rate has a small effect on the present value of earnings over a three-year period
but a large effect on the present value of earnings over the next 50 years. Note that this is the same argument as we used in
Chapter 17, in saying that a change in interest rates would have little effect on the price (present value of promised payments)
of a short-term bond but a large effect on the price of a long-term bond.
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