Monetary Policy Shocks and Heterogeneous Finance Decisions: A Model of Hidden Effort Choice and Financial Intermediation

Abstract

The paper investigates how monetary policy shocks influence the composition of firms' external finance given that firms are heterogeneous. Heterogeneity stems from differences in the availability of internal funds and in the monitoring costs associated with bank finance. These costs are determined by the intensity of the lending relationship. By using a delegated monitoring approach it is found that bank loans serve as substitute for internal funds if the lending relationship is sufficiently close. Moreover, banks with strong credit ties to their customers are not only able to protect borrowers from liquidity constraints following a monetary tightening but are even able to extend their business lending.

Keywords: Hidden effort, delegated monitoring, financial intermediation, monetary policy transmission, financial accelerator

JEL Classification: D8, E5, G2, G3