Ripple effects of monetary policy

Summary

Focus

When a firm cannot easily substitute financially constrained clients or suppliers in the face of an adverse monetary policy shock, the fall in demand or supply may create bottlenecks and induce the firm to cut back its activity. We refer to this as the "ripple effects" of monetary policy. This paper studies how conventional monetary policy transmits through the demand and supply of intermediate goods and the role of input-output linkages as transmission channels.

Contribution

We use detailed information on existing firm supply chains to investigate the ripple effects of monetary policy. We study the demand channel by analysing how firms' sales react to changes in monetary conditions as a function of their clients' financial health. We also study the cost channel by analysing the reaction of firms' purchases to changes in monetary conditions as a function of their suppliers' financial health. What is new in our approach is that we allow for monetary policy to work through the balance sheets of the firms' clients and suppliers, as well as through the firms themselves. 

Findings

Our main findings are twofold. Firstly, the balance sheet structure of downstream and upstream firms is a salient, yet mostly overlooked, element in the transmission of monetary policy. Secondly, changes in monetary conditions have a quantitatively larger impact on firms' operations through the changes in demand induced by clients' financial health, than through the firms' own balance sheets.

Abstract

Is conventional monetary policy transmitted through the demand for and supply of intermediate goods in an economy? Analyzing unique US data on corporate linkages, we document that downstream and upstream corporate financial health are instrumental for the transmission of monetary policy. Our estimates suggest that contractionary changes in monetary conditions lead to reductions in both the demand and the supply of all financially constrained business partners, thereby creating bottlenecks, which induce the linked firms themselves to curtail their own activities ("ripple effects"). Overall, our estimates suggest that changes in monetary conditions may have a quantitatively larger impact on firms' operations through the changes in demand and supply induced by constrained business partners than through the firms' own financial conditions.

JEL classification: E52, G32

Keywords: monetary policy transmission, supply chain, aggregate demand, cost channel