Financial constraints and the balance sheet channel: a re-interpretation

Aggregate demand models extending IS/LM fixed price framework yield an enhancement mechanism of the traditional monetary transmission mechanism, credit channel, which, according to the credit view, works through the balance sheet channel and the bank lending channel. In this paper I modify the augmented IS/LM model assuming that investments may be financed by both internal and external sources of funds. The inclusion of internal funds in the augmented IS/LM fixed price model suggests a different interpretation of the balance sheet channel as an enhancement mechanism amplifying monetary policy effects through the quantity rather than the cost of borrowing. Thus, changes in borrowers' net worth over the cycle can amplify and propagate output fluctuations directly rather than indirectly as in the traditional interpretation of the balance sheet channel. The empirical analysis of the monetary transmission mechanism for Italy in the last decade accords with the interpretation of the balance sheet channel proposed in this paper.