Financial Frictions and the Strength of Monetary Transmission

This paper examines the effect of financial frictions on the strength of the monetary transmission mechanism. Credit channel theory implies that the transmission mechanism of monetary policy should be stronger in countries with high levels of financial frictions, all else equal. The intuition is that in these countries, external finance premiums are more sensitive to firms’ financial leverage. By affecting asset prices, therefore, monetary policy has greater impact on external finance premiums and output. We test this theoretical prediction by estimating SVAR models on cross-country data to generate indicators for the strength of monetary transmission. We find a positive relationship between various measures of financial frictions and the strength of monetary transmission, supporting the predictions of credit channel theory.