Monetary Policy with Credit Market Frictions

Abstract: I study the role of collateral as a source of financial friction in the transmission of monetary policy towards firms' investments. First, I use a panel of Swedish firms to estimate the heterogeneity in firm investment responses to monetary policy shocks conditional on collateral. I find that highly collateralized firms are more responsive to monetary policy and significantly reduce investments relative to firms with low collateral after a contractionary monetary policy shock. Moreover, I provide empirical evidence of collateral based borrowing constraints to support the evidence that investment responses to monetary policy vary with collateral. To motivate these results, I develop a New Keynesian model with heterogeneous credit constrained firms calibrated to the Swedish economy. The model generates results that are consistent with the empirical evidence in that firms with high collateral are more responsive to monetary policy. Overall, the findings have policy implications in that monetary policy is shown to be more powerful in achieving price stability when firms face credit frictions and are highly collateralized.