The means by which monetary policy affects demand via banks and other credit institutions is usually called the credit channel. Higher interest rates make it more difficult for firms to obtain new loans, thus dampening activity in the economy.
The credit channel refers to the way in which monetary policy affects demand via banks and other credit institutions. Its effect is due to the fact that certain borrowers, mainly small and medium-sized businesses, are dependent on bank credit and are unable to borrow in the securities markets. This in turn is due to the high costs involved in obtaining information about borrowers’ creditworthiness. When a company borrows from a bank, only one party needs to assess the borrower’s creditworthiness. In the securities markets, where credits are funded by a large number of players, the costs of evaluation and monitoring are multiplied, unless the borrower is already a big, well-known firm, due for example to its shares being listed on a stock exchange.
If market rates rise, banks choose to decrease their lending and instead buy bonds. This reduces the availability of credit for the banks’ customers. At the same time, lending rates will probably rise, although it is not certain that firms that are willing to pay the higher interest rates will be granted credit. This is because of certain mechanisms that can result in borrowers who are willing to borrow at high rates of interest to be less inclined to pay back the loans. Accordingly, a company’s expected profitability falls when interest rates rise, which subdues demand. As a result, companies’ willingness and ability to bear debt decreases. Companies that are either unable to borrow or that do not want to borrow must scale back their activities, postpone investment and so on, and this dampens demand.
At the same time, banks can counter the effects of monetary policy by deciding not to raise their lending rates to trusted customers to the same extent as the increase in market rates. This reflects the often long-term nature of bank-customer relationships. A bank can therefore expect to recoup lost interest income during an economic boom, when customers will be willing to pay a little higher interest with the aim of safeguarding their long-term relationship with the bank. This counteracts the contractionary effect of higher key interest rates, but does not lead to a closing off of the credit channel, as there will be borrowers with less established bank relationships. Perhaps the best example of this is people with plans to start up a company.