Eggertsson and Woodford (2004) and Bernanke et al (2004)). Conversely, low interest rates can lead to more risk-taking when bank balance sheets are stronger. De Nicolò et al (2010) show theoretically that when the policy rate is low, high-charter value (well capitalised) banks may increase risk-taking and low-charter value (poorly capitalised) banks may do the opposite (see further Dell’Ariccia and Marquez (2013) for a discussion of the theoretical literature on the links between interest rates, bank capitalisation and risk-taking).

Suggestive of market imperfections and financial frictions, many studies document that the indirect effects of interest rates on activity can be quite large. Those studies, notably Bernanke and Gertler (1995), argue that additional factors related to financial imperfections can amplify and propagate the quantitative effect of the conventional direct interest rate transmission channel. Using aggregate time series data for the United States, Bernanke and Gertler (1995) show that because of frictions in financial intermediation, the transmission of monetary policy largely operates through the financial system and depends on the balance sheets of firms and households.

The quantitative importance of different mechanisms also depends on country-specific financial and institutional environments. In bank-based financial systems, where retail deposits typically play an important role in funding and a large share of investment is financed by banks, the direct interest channel can be expected to be more influential in transmitting the effects of interest rates (see Allen and Gale (2000)). Indeed, while the overall quantitative impact of changes in interest rates in the euro area is comparable to that reported for the United States, there is a larger direct effect on investment (relative to consumption) in the euro area. Angeloni et al (2003), for example, find that the interest rate channel characterises monetary policy transmission in some euro area countries.<sup>73</sup> By contrast, in the United States, complementary channels through which interest rates affect consumption and investment are more important (see Boivin et al 2011)).

# Limits to the predictive power of the yield curve

Some interpret the predictive power of the slope of the yield curve for economic activity as evidence of other channels. While many argue that the slope reflects expectations about the monetary policy stance, and its relationship to economic activity, others question the analytical foundations of this channel (Stock and Watson (2003)). Some give more credence to the view that the slope of the yield curve affects intertemporal consumption choices that lead to sales or purchases of assets in anticipation of changes in income (Campbell (1986)).

Others point out that the direction of influence can be from activity to the yield curve. In a dynamic model with rational expectations, Estrella (2005) shows that the term spread contains information about expectations of future activity and is affected by current monetary policy, which is, in turn, influenced by current activity. Using a state-space model that comprises yield curve and macroeconomic factors, Diebold et al (2006) document that the two sets of factor interact in both directions: macroeconomic variables affect the yield curve (perhaps through the central bank’s reaction function) and the yield curve influences macroeconomic variables.

Furthermore, in the finance literature, movements in the term structure are thought to reflect changes in (inflation) risk premia rather than (just) real activity. Advanced term structure models, which employ data on interest rates at different maturities, explain the

> 73 For the eurozone, see Kok Sørensen and Werner (2006) and van Leuvensteijn et al (2011). See also Mojon (2000) for an analysis of differences in financial structures across euro area countries and their implications for the interest rate channel.

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