International Review of Economics and Finance 13 (2004) 363 369

www.elsevier.com/locate/econbase

Monetary policy and the credit channel in an open economy

Carlos D. Ramrez *
Department of Economics, George Mason University, Fairfax, VA 22030-4444, USA
Received 22 May 2001; received in revised form 1 April 2003; accepted 23 April 2003
Available online 25 July 2003

Abstract

This paper extends Bernanke and Blinders [Am. Econ. Rev. 78 (1988) 435] credit-channel model to the
open economy. In particular, it examines whether the monetary policy results predicted by the popular
textbook Mundell Fleming model [e.g., Can. J. Econ. Polit. Sci. 29 (1963) 475; IMF Staff Pap. 9 (1962)
369] change with the open-economy version of the Bernanke and Blinder credit-channel model. This
examination is important to consider in light of the popularity of the Mundell Fleming model at the
policymaking level and in light of recent empirical findings giving strong support to the credit channel as a
monetary policy transmission mechanism. The main conclusion is that monetary policy is much more potent
under the open-economy version of the Bernanke and Blinder model than under the standard Mundell
Fleming model.
D 2003 Published by Elsevier Inc.

JEL classification: E51; F41

Keywords: Credit-channel model; Mundell Fleming model; Monetary policy; Interest rates

1. Introduction

It is well known that, at least in the short run, monetary policy affects real economic activity. The
monetary economics literature highlights two mechanisms through which this happensthe money
channel and the credit channel. The standard textbook money channel emphasizes that, through
open-market operations, central banks can directly affect real interest rates (in the short run), thus the

* Tel.: +1-703-993-1145; fax: +1-703-993-1133.

E-mail address: cramire2@gmu.edu (C.D. Ramrez).

1059-0560/$ - see front matter D 2003 Published by Elsevier Inc.

doi:10.1016/S1059-0560(03)00038-8
364 C.D. Ramrez / International Review of Economics and Finance 13 (2004) 363369

cost of capital. The credit channel emphasizes that open-market operations also directly affect banks
loan supply schedules. Thus, the central bank not only affects the interest rates of government
securities, but also the effective spread between bank loan rates and the rate of government
securities.1
One of the more celebrated theoretical papers that emphasizes the credit-channel view is that of
Bernanke and Blinder (1988) (henceforth referred to as BB). They extend the standard ISLM
model by explicitly modeling the loan market independently from the money market. By separating
the loan and money markets, they are able to show that an increase in the money supply increases
output not only through the standard money market, but through the loan market as well. As a
result, their model predicts that expansionary monetary policy has a more potent effect on output
than that which the standard ISLM model predicts, without necessarily affecting the level of
interest rates.
The purpose of this paper is to extend BBs model to the open economy. In particular, I examine
whether the monetary policy results predicted by the popular textbook MundellFleming model (e.g.,
Fleming, 1962; Mundell, 1963) (henceforth referred to as MF) change with the open-economy version of
the BB model. This examination is important to consider in light of the popularity of the MF model at
the policymaking level and in light of recent empirical findings giving strong support to the credit
channel as a monetary policy transmission mechanism.
The main conclusion is that monetary policy is unambiguously more potent under the open-
economy version of the BB model than under the standard MF model. This result comes about
because of two reasons. First, just as in the BB model, separating the loan from the bond market
makes aggregate investment much more directly responsive to changes in the money supply. Second,
the credit channel makes the balance of payments more sensitive to interest rate fluctuations. This last
result depends on the share of foreign bonds that the domestic banking sector invests in as part of its
portfolio.
The approach taken here to model the open-economy version of the BB model is inspired by Freixas
and Rochets (1997) version of the standard ISLM model. I use their version for the sake of simplicity
and clarity.
This is not the first paper that has investigated this issue. In a recent article, Wu (1999) examines
the role of monetary policy under a fixed-exchange regime with an operative credit channel. His main
conclusion is that monetary policy can be effective in stimulating output even under a fixed exchange
rate regime. His results, however, hinge on the critical assumption that the amount of foreign
exchange reserves is kept constant in the model. This assumption is incorrect because the quantity of
foreign exchange reserves becomes endogenous under a fixed exchange rate regime. Ramirez (2001)
shows that when this assumption is relaxed, the ineffectiveness of monetary policy in stimulating
output under a fixed exchange rate regime is restored, even though the credit channel is operative in
the model.

1
There is a large empirical literature (in fact, too large to list here), which suggests that the credit channel is an important
mechanism through which monetary policy affects output. Example of papers that not only provide evidence, but also survey
some of the empirical literature, are Bernanke and Blinder (1992), Bernanke and Getler (1995), and Kashyap and Stein (1994,
1997), to name just a few.
 C.D. Ramrez / International Review of Economics and Finance 13 (2004) 363369 365

2. Simple credit model in the open economy

2.1. Sectors

2.1.1. Households
The real income of households, y, along with the interest rate in domestic and foreign bonds, rb and
rb*, determine real savings S( y,rb,rb*). I assume imperfect substitutability between domestic and foreign
bonds. Hence, households allocate their savings between three assets: money (D), domestic bonds (B),
and foreign bonds (B*)2,3:





y * h * h y * * h *
S ; b; b B
r r r r
b; b D ; b; b B
r r r r
b; b 1
   

Where the sign of the partial derivatives is indicated below each variable in the equations, the
superscript h denotes households and the subscript b denotes bonds. To keep the analysis as simple
as possible, the demand for domestic and foreign bonds are assumed to depend only on the interest
rates.

2.1.2. Firms
Firms finance their investment (I ) by issuing bonds (B f ) or by borrowing from the banking sector (L f ):




I rb ; rL B f rb ; rL Lf rb ; rL
   

The rL denotes the interest rate in the loan market.

2.1.3. Banks
I assume that banks are risk-averse, and hence, invest deposits on domestic bonds (Bb), foreign bonds
(B*b), loans (Lb), and reserves (R).4 In the BB model, bank-demand functions for loans and bonds are
simplified as being proportional to the level of reserves. The factors of in turn, functions of the interest
rates in the bond and loan markets.
Dh R Lb Bb B*b
with:


b
L l rb ; rb*; rL R
 

2
Standard portfolio-allocation models predict that, under risk-aversion, the demand for all three assets will be nonnegative
and will depend on relative returns.
3
Technically, savings should be allocated among the flow of these three assets, not the stock levels. Thus, to avoid
confusion, I define D, B, and B* to represent increases in money, domestic bonds, and foreign bonds. This definition also
applies to other stock variables introduced in the model further below.
4
The assumption of risk-aversion for banks is done to ensure that there will be demand for all three assets. It is worth
pointing out that portfolio-allocation models with risk-aversion in banking have a large history in the literature. Some of the
well-known papers include Pyle (1971, 1972). For a comprehensive survey, see Santomero (1984).
366 C.D. Ramrez / International Review of Economics and Finance 13 (2004) 363369


b *
B k b; b; L R
r r r
 


b *
B* a b ; b ; L R
r r r
 

Assuming a fractional banking system and that those bank holdings of reserves are determined by the
required reserve ratio, c, alone, we have:

R cDh Z 1  cDh Bb B*b Lb

2.1.4. Government
To simplify the analysis, assume that the governments expenditures are financed by issuing bonds
(Bg ) and by reserves:

G Bg R

2.1.5. Balance of payments

In keeping with accounting conventions, the balance of payments is defined as the current account
balance (NX) minus capital outflows (B*) (alternatively, plus capital inflows):



0 NX q; y  B* rb ; rb*; rL
  

B*rb ; rb*; rL uB* rb ; rb* B*b rb ; rb*; rL

h

Where q is the real exchange rate, measured as domestic units relative to foreign units.

2.2. Equilibrium equations

In its reduced form, the model is fully described by the following four equations:

 Equilibrium in the credit market (Cr):



f
rb ; rL l rb ; rb*; rL R
L
  
Cr

Z rL / rb ; rb*; R

 C.D. Ramrez / International Review of Economics and Finance 13 (2004) 363369 367

 Equilibrium in the goods market:



* h y *
IS r r r
I b ;/ b ; b ;R GS r r
; b; b
  



B* rb ; rb*; / rb ; rb*; R
  

 Equilibrium in the money market:

!
h y; rb ; rb*
LM R cD
 

 Equilibrium in the balance of payments (BoP):




BoP 0 NX q; y  B* rb ; rb*; / rb ; rb*; R
   

2.3. Monetary policy multipliers

The endogenous variables in this model are income, the domestic level of interest rates, and the
exchange rate (under a floating exchange-rate regime).5 Under the assumptions of the model, the
following results hold.

2.3.1. Effect on interest rates



@rb Sy  cDy I/ /R B/*/R
<> 0
@R cSy Drb Dy hV

Where the subscripts indicate partial derivatives of the equilibrium equations, and h Vis:

hVu  Srb  Irb  Br*b  I/ /rb  B/*/rb < 0

This first result implies that an increase in reserves (or high-powered money) has an ambiguous effect
on the domestic level of interest rates, just as the BB model predicts. This contrasts with the results of the
standard model, which predict a negative effect of monetary policy on interest rates. In this model, the
effect is not as negativeand may even be positivebecause I//R (the responsiveness of investment
demand to changes in the interest rate on bank loans times responsiveness of the interest rate on bank
loans to changes in money supply) and B/*/R (the responsiveness of demand for foreign bonds to
changes in the interest rate on bank loans times responsiveness of the interest rate on bank loans to

5
I consider only the floating exchange rate regime because under a fixed exchange regime, monetary policy is ineffective.
368 C.D. Ramrez / International Review of Economics and Finance 13 (2004) 363369

changes in money supply) temper the effect of money on interest rates. If these elasticities are high
enough, the effect may be zero or even positive. Thus, with an operative credit channel, it is possible for
an increase in the level of high-powered money to affect real economic activity without a concurrent
large negative effect on interest rates.

2.3.2. Effect on exchange rate


Bq
BR


Sy cDrb B/*/R Br*b B/*/rb hVcDy B/*/R  NXy  I/ /R B/*/R cDy Br*b B/*/rb cDrb NXy
<> 0
cNXq Sy Drb Dy hV

Whereas the exchange rate depreciates as a result of the money expansion under the standard MF model,
in this extension of the model, the result is different. We can no longer unambiguously claim that the
exchange rate will depreciate here because it is not possible to tell what will happen to the domestic level
of interest rates.

2.3.3. Effect on output



@y cDrb I/ /R B/*/R h V
>0
@R cSy Drb Dy hV

Thus, just as in the standard MF model, an increase in money increases real output. The question that
remains is whether this effect is larger or smaller than that which occurs under the credit version of the
model.

Result: Monetary policy is more potent in the open-economy credit model than under the MF model.

Proof: It can easily be shown that the monetary policy effect on output under the standard MF model is:6
 

@y h
>0
@R Sy Dr Dy h
hu  Sr  Ir  Br* < 0 5

To show that the open-economy version is larger, I decompose the effect on output of the open-
economy credit model to:




@y Dr I//R B/*/R hV

@R Sy Dr Dy hV Sy Dr Dy h V
|{z} |{z}
A B
Because A>0, all I need to show is that the effect of monetary policy on output in the MF model is
smaller than B. But this immediately follows after noticing that B increases with the magnitude of hVand

6
In this case, rb=rL=r.
 C.D. Ramrez / International Review of Economics and Finance 13 (2004) 363369 369

that the magnitude of h is smaller than that of hV.7 (Concluding remarks). This discussion extends the
credit model that Bernanke and Blinder (1988) developed for the open economy. The main finding is
that monetary policy is unambiguously more potent under this extension of the model than under the
standard textbook version of the MF model.. This result underscores the importance of the credit channel
for small open economies. Given the overwhelming evidence suggesting that the credit mechanism is an
empirically important channel through which monetary policy affects output, a clear implication of this
result is that the cost of adopting a fixed exchange rate regime or joining a common-currency area should
be revised to a higher level.. The theoretical conclusion of this paper suggests that it may be interesting
to quantify the extent to which the credit channel affects the impact of monetary policy empirically. I
plan to investigate this in future research.

Acknowledgements

I would like to thank Gian Maria Milesi-Ferretti, Ling Hui Tan, Willem Thorbecke, as well as two
anonymous referees for helpful comments and suggestions.

References

Bernanke, B., & Blinder, A. (1988). Credit, money and aggregate demand. American Economic Review, 78, 435 439.
Bernanke, B., & Blinder, A. (1992). The federal funds rate and the channels of monetary transmission. American Economic
Review, 82, 901 921.
Bernanke, B., & Getler, M. (1995). Inside the black box: The credit channel of monetary policy transmission. Journal of
Economic Perspectives, 9, 27 48.
Fleming, J. M. (1962). Domestic financial policies under fixed and floating exchange rates. International Monetary Fund Staff
Papers, 9, 369 379.
Freixas, X., & Rochet, J. -C. (1997). Microeconomics of banking. Cambridge: MIT Press.
Kashyap, A., & Stein, J. (1994). Monetary policy and bank lending. In N. G. Mankiw (Ed.), Monetary policy ( pp. 221 261).
Chicago: University of Chicago Press.
Kashyap, A., & Stein, J. (1997). What do a million banks have to say about the transmission of monetary policy? National
Bureau of Economic Research Working paper, 6056.
Mundell, R. A. (1963). Capital mobility and stabilization policy under fixed and flexible exchange rates. Canadian Journal of
Economics and Political Science, 29, 475 485.
Pyle, D. H. (1971). On the theory of financial intermediation. Journal of Finance, 26, 737 747.
Pyle, D. H. (1972). Descriptive theories of financial institutions under uncertainty. Journal of Financial and Quantitative
Analysis, 7, 2009 2029.
Ramirez, C. D. (2001). Even more on monetary policy in a small open economy. International Review of Economics &
Finance, 10, 399 405.
Santomero, A. M. (1984). Modeling the banking firm: A survey. Journal of Money, Credit and Banking, 16, 576 602.
Wu, Y. (1999). More on monetary policy in a small open economy: A credit view. International Review of Economics &
Finance, 8, 223 235.

7
rb increases, h Valso increases in magnitude, and hence, the effect of the credit
Note that as the degree of capital mobility (B*)
channel on the multiplier diminishes in relative importance.