Interest Rates, Banking Spreads and Credit Supply : The Real Effects
In a standard IS-LM model, the effects of monetary policy on real activity are felt through the demand for money and the (unique) interest rate. In reality, shocks in monetary policy will affect the relative structure of interest rates given imperfect substitution among financial instruments. In this paper we analyse the information content of the relative structure of interest rates on economic activity. Over and above currently defined spreads, we have defined spreads based on bank determined interest rates. The importance of these spreads is straightforward. In real economies, debt finance is the major source of external funds. Moreover, under realistic conditions of information asymmetry, loans from financial intermediaries are special. The expertise acquired by banks in the process of evaluating and screening applicants, and in monitoring loan performances enables them to extend credit to customers who find it difficult or impossible to obtain credit in the open markets. A reduced supply of loans or a rise in the cost of borrowing may depress the economy, to the extent that some borrowers are dependent on bank loans for credit.
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