External finance, and the credit channel of transmission of monetary policy in the UK manufacturing industry
Understanding the mechanism through which monetary policy affects real economic activity is a very important issue for attaining macroeconomic stability. Financial innovations during the last two decades and imperfections in the financial markets make this mechanism more complicated. The link between policy and real activity can be better understood by taking into consideration the variety of financial assets, agency costs, micro level information involved in financial transactions and identification of supply and demand effects. We provide a theoretical review where monetary policy affects the real activity not only through the traditional 'interest rate channel' but also by changing the financial positions of firms. In this framework, we identify the responses of firms with various characteristics to monetary policy shocks through the financial accelerator where credit market conditions amplify and propagate the impact of monetary shocks on real activity of financially weak and small firms. Agency costs and other informational problems are more influential on the availability and cost of financial sources and financial choices for these firms, which is very important for the economic performance. We test these predictions empirically by using a panel of more than fifteen thousands UK manufacturing firm records during the period of 1990-1999. We show that the financial choices of small, young, risky and highly indebted firms are more sensitive to tight monetary conditions than those of large, old, secure and low indebted firms. The evidence is consistent with the credit channel where monetary policy has distributional implications for the bank dependent firms that face difficulties in getting external finance during tight periods. We also test the impact of policy on firms' inventory investment and employment growth by taking into account base rate to capture the user cost of capital, the ratio of the short term debt to current liabilities, and cash flow in addition to other control variables across firm characteristics by using dynamic panel estimation procedures. This framework enables us to avoid some empirical issues, e.g. identification concerning cash flow, ad hoc sample splitting criteria (classifying firms as financially constrained or unconstrained) and endogeneity problem between firm specific variables and inventory investment and employment. Financial variables consistently explain both inventory investment and employment growth across firm groups but the former is more sensitive to the financial variables and the monetary policy stance. Our results imply that the financial structure of firms makes a difference for their real activity, therefore verifying the credit channel for the UK economy.