Lending Relationships and Monetary Policy

Financial intermediation and bank spreads are important elements in the analysis of business cycle transmission and monetary policy. We present a simple framework that introduces lending relationships, a relevant feature of financial intermediation that has been so far neglected in the monetary economics literature, into a dynamic stochastic general equilibrium model with staggered prices and cost channels. Our main findings are: (i) banking spreads move countercyclically generating amplified output responses, (ii) spread movements are important for monetary policy making even when a standard Taylor rule is employed (iii) modifying the policy rule to include a banking spread adjustment improves stabilization of shocks and increases welfare when compared to rules that only respond to output gap and inflation, and finally (iv) the presence of strong lending relationships in the banking sector can lead to indeterminacy of equilibrium forcing the central bank to react to spread movements. JEL Codes: E44, E52, G21 Keyword: Endogenous Banking Spread, Credit Markets, Cost Channel of Monetary Transmission, Firm-bank Relationships ∗We would like to thank Paul de Grauwe, Nils Gottfries and seminar participants at the Bank of England, Bank of Finland/CEPR Conference in Helsinki, Riksbank, Cagliari University, Catholic University of Leuven and Uppsala University for comments. The usual disclaimer applies. †School of Economics, Mathematics and Statistics, Birkbeck, University of London, Malet Street, WC1E 7HX, London, United Kingdom, Tel: +44 20 7631 6407, Fax: +44 20 7631 6416, e-mail: [email protected] ‡Corresponding Author. Department of Economics, Uppsala University, P.O. Box 513, SE-751 20, Uppsala, Sweden, e-mail: [email protected] §Department of Economics and Finance, Brunel University, Uxbridge, Middlesex, UB8 3PH, United Kingdom, e-mail: [email protected]