Interest rate pass-through and credit spread in new keynesian models. Theoretical and empirical relevance

The behavior of banks and the determination of retail interest rates have taken a prominent role after the recent financial crisis: high levels of the cost of credit and quantity rationing are characterizing the actual economic environment. Monetary policy has sought to address the setting of bank rates by continuous operations on the monetary policy rate. Nevertheless, the adjustment of bank rates has not been complete. The aim of this dissertation is to show that the incomplete pass-through of policy rate changes on the loan rate may depend also on market frictions, in particular those existing in the credit market. To this aim, we present three self-contained but highly correlated papers in which we discuss the role of these frictions, and their interplay with those existing in the labor market, on the size of the interest rate pass-through and its relevance in shaping business cycle dynamics. The study of interest rate dynamics also allows us to focus on the cyclical behavior of the credit spread, which is often used as a leading indicator of the economic activity. In order to shed light on these issues, we employ a New Keynesian framework (Walsh, 2003) which offers a convenient setting for monetary policy analysis. What is relevant in this model is the so-called “cost channel” that links the current and the expected future real marginal costs of the productive sector of the economy with inflation and then with the business cycle dynamics. If, as in this work, the loan interest rate enters the definition of marginal costs, it can affect the dynamics of the main macroeconomic and financial variables. Theis dissertation is organized as follows. In chapter 1, after reporting the empirical and theoretical literature on the interest rate passthrough and the credit spread, we present a critical survey that uses Bayesian techniques to compare models which explain the interest rate on loans on the basis of different theoretical mechanisms. In particular, we propose a model - to be more detailed in chapter 2 - in which credit market frictions are modeled by the search and matching technology. We conclude that the specification which benefits from the most favorable evidence is one in which the banking lending rate depends on its past value, as well as on credit market frictions. In chapter 2 we describe a New Keynesian model with search and matching frictions in the credit market and we derive a definition of the banking lending rate which depends on the aggregate credit market tightness. We estimate and simulate the model with respect to monetary, technology and credit shocks and we highlight both the incompleteness of the interest rate pass-through and the countercyclical behavior of the credit spread. We also show the importance of the bargaining power of banks to explain the degree of (in)completeness of the interest rate adjustment, as well as the (more or less) countercyclical behavior of the credit spread. In chapter 3 we study the interplay of search and matching frictions in the labor and in the credit markets, focusing on monetary policy disturbances. We confirm that the incompleteness of the interest rate pass-through depends on some deep parameters, such as the relative bargaining powers and the search costs of agents. By comparing the model outcomes with those which obtain with parameter values generating a complete pass-through, we show that the transmission of monetary policy shocks to output and inflation is more relevant than suggested by the recent literature, even though the presence of credit market frictions has a moderation effect on the main macroeconomic dynamics.