Bank Behavior and the Cost Channel of Monetary Transmission. CESifo Working Paper No

This paper provides a micro-foundation of the behavior of the banking industry in a Stochastic Dynamic General Equilibrium model of the New Keynesian style. The role of banks is reduced to the supply of loans to firms that must pay the wage bill before they receive revenues from sell-ing their products. This leads to the so-called cost channel of monetary policy transmission. Our model is based on the existence of a bank–client relationship which provides a rationale for monopolistic competition in the loan market. Using a Calvo-type staggered price setting approach, banks decide on their loan supply in the light of expectations about the future course of monetary policy, implying that the adjustment of loan rates to a monetary policy shock is sticky. This is in contrast to Ravenna and Walsh (2006) who focus primarily on banks operating under perfect competition, which means that the loan rate always equals the money market rate. The structural parameters of our model are determined using a minimum dis-tance estimation, which matches the theoretical impulse responses to the empirical responses of an estimated VAR for the euro zone to a monetary policy shock