Intellectual Merit: A central question in monetary economics is how monetary policy affects real activity over the business cycle. One widely held view is that it does so through the credit channel, by affecting the rates at which banks borrow and lend, and by affecting the balance sheets of firms, particularly for firms with limited access to financial markets. This proposal describes three projects aimed at investigating the quantitative importance of the credit channel and the implications of theoretical models of the credit channel for the conduct of monetary policy. The first proposed project is empirical and analyzes the business cycle characteristics of the size distribution of firms, price-cost margins, labor productivity, borrowing costs and other measures of financial constraints, all by firm size. The focus on firm size is motivated by the idea that larger firms have better access to financial markets. This analysis covers widely-used and new data for the postwar period and the Great Depression for the United States as well as postwar data for a number of other countries. The PI's have obtained approval from the Census Bureau for access to an extensive detailed collection of data at the plant and firm level since the 1970s. A panel tracking the behavior of plants and the characteristics of their associated firms will be constructed using this data and data from publicly available sources. Preliminary findings suggest that, over the business cycle, small and large firms (with very different access to capital markets) behave very similarly, but following monetary contractions small firms contract disproportionately relative to large forms. The second project builds a model consistent with the findings of the first project. In the model, financial frictions affect the use of working capital, particularly for small firms. Larger firms are less affected by these frictions because they have greater access to public financial markets. A monetary contraction disproportionately affects small firms and distorts their use of working capital relative to other inputs. Over the business cycle, productivity shocks affect both types of firms similarly as long as monetary policy is appropriately accommodative. Preliminary versions of the model suggest that while it is promising other mechanisms may be needed to amplify the e¤ects of shocks. The third project is intended to develop an amplification mechanism. We describe a model in which small firms discipline the monopoly power of large firms. Financial frictions disproportionately affect small firms. In recessions, financial frictions worsen and small firms marginal costs rise relative to those of large firms. The economy becomes less competitive and the resulting distortions provide a possible amplification mechanism. Furthermore, in the model, the labor wedge rises in recessions much as it does in the data.
Broader Impacts: The broader impacts are that the projects will help improve the conduct of monetary policy over the business cycle. The projects will also help in the design of regulatory policy aimed at the banking and financial services industry and in the design of policies aimed at new and small firms. The research described here will be disseminated broadly. It will be published in academic journals as well as in publications by the Federal Reserve System and publications which are intended for fiscal and regulatory policymakers.
