This paper studies the limitations of monetary policy transmission within a credit channel framework. We show that, under certain circumstances, the credit channel transmission mechanism fails in that liquidity injections by the central bank into the banking sector are hoarded and not lent out. We use the term ‘credit traps’ to describe such situations and show how they can arise due to the interplay between financing frictions, liquidity, and collateral values. Our analysis offers a characterization of the problems created by credit traps as well as potential solutions and policy implications. Among these, the analysis shows how quantitative easing and fiscal policy acting in conjunction with monetary policy may be useful in increasing bank lending. Further, the model shows how small contractions in monetary policy or in loan supply can lead to collapses in lending, aggregate investment, and collateral prices.
Does short-term debt increase vulnerability to financial crisis, or does short term debt reflect - rather than cause - the incipient crisis? We study the role that short-term debt played in the collapse of the East Asian financial sector during the crisis of 1997-1998. We alleviate concerns about the endogeneity of short-term debt by using long term debt obligations that matured during the crisis. We find that debt obligations issued at least three years prior to the crisis had a negative, albeit sometimes insignificant effect on the probability of failure. Our results are consistent with the view that short-term debt reflects, rather than causes, distress in financial institutions.