cyclicality has a positive and significant impact on labor productivity when industry is credit‐ constrained.<sup>54</sup> A recent report, Ball et al (2016), assesses past theories and recent empirical evidence on the tools available to central banks and their effectiveness, concluding that it remains effective in raising aggregate demand (even in the presence of deleveraging), and easing credit supply. Both the bank credit channel and the bond market/risk premia channels (portfolio balance channel) are important for output recovery. Romer and Romer (2013) demonstrate that it is dangerous to assume that monetary policy should not be used as it is not effective.

**Figure12.a: Official interest rates (%)                              Figure 12.b:  Balance sheets, FED and ECB** (Trillions of dollars or euros)

<!-- Start of picture text --> 6<br>5<br>4<br>3<br>2<br>1<br>0<br>FED ECB BoJ BoE<br>2007‐01 2007‐07 2008‐01 2008‐07 2009‐01 2009‐07 2010‐01 2010‐07 2011‐01 2011‐07 2012‐01 2012‐07 2013‐01 2013‐07 2014‐01 2014‐07 2015‐01 2015‐07<br><!-- End of picture text --> <!-- Start of picture text --> 5<br>4<br>3<br>2<br>1<br>0<br>ECB FED<br>2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015<br><!-- End of picture text --> Source: ECB and Federal Reserve Bank of St. Louis.

Weekly data. FED: FED, Federal funds (effective) rate ECB: ECB, Main refinancing operations interest rate BoJ: Bank of Japan, Basic discount rate and basic loan rate BoE: Bank of England, Official bank rate Source: FED, ECB, BoJ, BoE.

# **Lesson 7: Monetary policy is only as good as the transmission mechanism.**

_<u>As growth recovery struggled, debates surrounding the effectiveness of different types of monetary instruments and the desired</u> “looseness” of policy abounded. Over time, the ECB’s policies_ _<u>became looser, but were hindered from having a commensurate effect because of structural features of financial markets and/or incomplete restructuring of balance sheets among firms, households and banks.</u>_ Monetary policy is transmitted through the financial system to borrowers and thus its ability to stimulate demand and manage inflation depends on the structure and incentives in the financial system as well as in the economy at large (firms and households). Structural factors in the financial system include the degree of market competition, the extent of information asymmetries present, volatility and uncertainty, credit risk in the economy, or on the consumer side, costs for bank switching.<sup>55</sup> They also include changes in household preferences or the financial health of borrowers, expectations of global demand and government finances. For example, in a study of interest rate pass through in Portugal, Rocha (2012) finds that there is incomplete long run pass‐through from interbank rates (an indicator of the monetary policy stance) to corporate lending rates in the long run. The ECB, studying the four largest euro area countries, France, Germany, Italy and Spain, has also found that policy rate cuts since late 2011 have broadly lowered interest rates to NFCs in France and Germany, but the pass‐ through has been much less in the other two countries studied, Spain and Italy. This is in contrast to the situation in 2008‐09 when

> 54 The large literature on monetary policy non‐neutrality is not considered here, but mostly its impact on financial markets through the credit channel.

> 55 More competitive financial sectors, alternative sources of finance, good enforcement procedures, and good growth prospects would reduce lending rates.

27