Contract Rigidity in Municipal Financing and Monetary Policy Transmission to the Real Economy

Abstract

We study how financial contract structures in municipal financing influence regional heterogeneity in monetary policy transmission to the real economy. We identify our results exploring variation in municipal bond callability during the 2008 Federal Reserve easing cycle. We show that contractual flexibility led to greater bond issuance, expanded investments, and reduced interest expenses. These fiscal activities translated into higher income and lower unemployment at the local level. Our findings highlight local governments' significant role in shaping monetary policy transmission, revealing how their financial flexibility can either amplify or diminish the broader economic effects of monetary policy.

Keywords: Financial contracts, financial constraints, monetary policy, municipal bonds JEL CLASSIFICATION: G32, G32, G18, G38, E52, H72, H74