Tuesday, March 27, 2012


By Lanre Richard Igandan

Lanre Richard IgandanMonetary policy issues especially sudden monetary shocks have major effects on the economy at least in the short run. Therefore, it is necessary for policy makers to be aware of the implications of their policies on economy. This research by Lanre investigates the extent of the level of the monetary transmission mechanism and the financial accelerator effect on investment possibilities in the oil industry. In order to carry out this investigation, the interest rate channel and credit channels were reviewed alongside other channels such as the foreign exchange and equity price channels. Under the financial accelerator effect, the credit channel has been critically examined. Lanre finds out that monetary policies by the Central Bank has an effect on the level of investment in the oil industry as rising interest rates and inflationary pressures and constrained access to credit under a contractionary monetary policy will negatively affect investment possibilities in the oil industry. 

Monetary policy issues especially sudden monetary shocks have major effects on the economy at least in the short run. The schema of the monetary transmission process in any economy starts with the action of the monetary authorities and the response of financial variables such as money and interest rates. Therefore, it is necessary for policy makers to be aware of the implications of their policies on economy. Bernanke (1983) posits that there are two channels dit channels. Furthermore, Bernanke and Gertler (1989) substantiate the notion that changes in the financial and credit situations are significant in the propagation of the business cycle in what they dubbed as the ‘Financial Accelerator’. 

With oil being a global commodity and a basic input in the production process, its influence on the macroeconomy has been on the rise. Since the 1970’s the oil industry has witnessed shocks related to oil prices. The degree to which these shocks have impacted on several economies lies in part to their relative dependence on the commodity. i.e. whether they are partial of full importers. Exporters too do feel the brunt of increases in oil prices as there is a consequence of inflationary pressure that accompanies such a shock. By extension, this general increase in prices of goods and services affects the level of consumption and investment demand in the economy. How does the interest rate and credit channel come into play in this scenario|? For economies driven mainly by crude oil, it portends a dangerous signal to the development of the inherent oil industry in terms of accessing funds in the form of foreign direct investments. How do these variables enunciated above all relate to each other? 

 The objective of this research is to investigate the monetary transmission mechanism and how the financial accelerator effect influences investments in the oil industry. The analysis aims to contribute to the body of knowledge in investigating the far reaching consequences of these two key concepts on the oil and gas industry as any positive or negative developments in the oil industry have an effect (may be larger) on all other sectors of the economy and even on the production possibilities of an economy. 
A review of literature on the monetary transmission mechanism would indeed commence with the works of Ben Bernanke who is the present Chairman of the Board of the US Federal Reserve Bank (also called the Fed). In his brilliant scholarly work in 1983 - “Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression”, he outlined the two channels (interest rate and credit channels) that may have worsened the financial crisis during the great depression of the 1930s in the USA. However, Cecchetti (1994) reports that modern investigation of the influence of money on the macroeconomy was birthed by Friedman and Schwartz in 1963 in their book titled “A monetary history of the United states 1867-1960”; they provided support that monetary policy plays a significant role in aggregate fluctuations in the economy. 
Following Bernanke’s research work on the USA, there are a number of recent studies on the significance of the credit channel of the monetary transmission mechanism in some European countries include studies by and Haldane (1994) for Spain; Dale Buttiglione and Ferri (1994) for Italy. The studies found out different effects of the credit channel on the different economies (Fountas and Papagapitos, 2001). 
Considering the financial accelerator, Bernanke and Gertler (1989) indicated how the effects of a real shock on financial conditions may result in constant fluctuations in an economy, even if the initiating shock had little or no inherent persistence. In the same vein, there have been studies showing support for the financial accelerator through quantification attempts by Fuerst (1997). Kiyotaki and Moore (1997) have also examined the influence of leverage on the financial accelerator and have found useful evidence that it is important in the influence of the financial accelerator to amplify shocks. 
In relation to oil industry, the effects of the oil shocks of the 1970’s influenced research by economists on the possible effects of oil price increase on the macroeconomy. Pierce and Enzler (1974) in their study of the effects on oil price on oil demand view large increase in oil prices as an exogenous inflationary shock while Hickman et al. (1987) view it as a form of wealth transfer from oil importers to oil exporters. The overall effect was that there was reduced demand for oil evident in low Gross Domestic Product (GDP) thus leading to a rise in unemployment. 

Monetary Transmission Mechanism 
The thrust of monetary policy by the Central Bank of a country is to improve the performance of
 the sectors of an economy through the actions in setting interest rates, targeting inflation rates leading to the reduction in levels of unemployment. These actions target the household consumption and the firm’s investment abilities in maintaining an economic balance. Following Bernanke and Gertler (1989) identification of the two channels of monetary transmission, the general workings of both constructs are discussed below. 
Interest rate Channel 
The interest rate channel connects to economic activity principally through consumption and investment. An increase in money supply reduces the real interest rate which translates to a stimulation of investment and therefore economic activities. This is the traditional Keynesian model. The premise here is that reduced nominal interest rates lead to reduced real interest rates based on the assumption that prices are fixed at least in the short run. A monetary policy that leads to a fall in interest rates reduces the cost of borrowing capital for investment which therefore results in increased economic activity by way of increased exploration in new frontiers and also appraisal drilling potentials. A fall in the interest rates will also favour consumption decision as people will be willing to consume now rather than wait for the future. In contrast and relating this concept to the Energy sector, a rise in the interest rate will increase the cost of capital borrowing by the oil & gas companies and therefore will negatively affect their demand decisions concerning exploration and production. The net effect is that aggregate demand will fall. (See fig. 1). 

Fig1: The Interest rate channel. 
Source: Adapted from Bowers, P., (2009) Lecture notes on Economics for Business Managers. 

In a situation whereby investors in the energy sector do not have a choice but to access funds at high interest rates, it may lead to an increase in the price of the resultant commodity. For example, an increase in the price of oil may adversely affect aggregate demand (consumption + investment) and unemployment. Consumption will decrease because the level of disposable income will be affected while investment will be affected due to uncertainties thereby leading to a delay in investment decisions (Ferderer, 1996). By implication, the increase in oil price for an importing country may lead to losses in economic output if monetary authorities do not maintain nominal GDP constant through unexpected inflation. However, Bernanke et al. (2007) contend that after a decline in oil prices, real wages must grow to clear the markets. 
The downside of increased money supply and lower interest rates is that it can lead to inflation. However, this should not be seen only on the negative side as higher inflation expectations can be helpful to an economy experiencing deflation. At a nominal interest rate of zero percent, an expansionary monetary policy can still be effective in raising the expected price level and hence inflation thereby resulting in lower real interest rate. Mishkin (1996) asserts this mechanism was a vital element in monetarist arguments on why the U.S. economy was not stuck in a liquidity trap during the Great Depression of the 1930s and why expansionary monetary policy could have been used to prevent output decline in the period. As experienced earlier by Japan, the likelihood of future lower prices gives firms and consumers alike a leeway to delay their spending and this further result in a deeper recession. One way out of this may be to create inflation expectations so that it reverses the reduction in their spending habits. 

Credit Channel 
 The credit channel of monetary transmission mechanism can be viewed from two perspectives-the bank lending and the balance sheet channels. Mishkin (1996) is of the view that the bank lending channel is a consequence of market failure related to information asymmetries between borrowers and lenders. In the bank lending channel, an increase in the interest rate leads to a fall in the prices of bonds thereby leading to a fall in the value of reserves as well as a decline in shareholder equity. This reduces availability of bank credit which therefore makes banks to restrict loans. This action by the banks stifles the investment and production abilities of the oil exploration and production companies who are dependent on the banks for financing their projects. What are the implications of this action to an economy? 

For a country whose GDP is heavily dependent on the income received from crude oil production, there could be a deficit as government spending will tend to exceed revenues from taxes et al. due to reduced revenues accruable to the government. In the periods of credit crunch, a quantitative easing (some sort of expansionary monetary policy) by the Central Bank leads to an increase in deposits and bank reserves and therefore reduces the restrictions on the availability of credit . This in turn has a multiplier effect on investment levels to boost economic activities. 

In similarity to the bank lending channel, the balance sheet channel is also related to the issue of information asymmetries (Mishkin, 1996). It harps on the credit-worthiness of the firms due to procyclical variations in their balance sheets. The similarity in these two variants within the credit channel is that they both stress the supply of money to the operating companies. The balance sheet channel is mainly concerned with the ability of borrowers to repay their loans due to their net worth. This is more of an issue because the bank stands to lose more should the borrower’s project fail. In this situation, an expansionary monetary policy can also be formulated in the form of reduced interest rates which increases demand for money and results in a rise in bond prices. Furthermore, this policy will stimulate higher aggregate demand which will positively affect GDP and revenues. 

The monetary transmission mechanism discussed above is mainly of a Keynesian approach. Monetarists in the likes of Milton Friedman however picture a transmission mechanism in which other asset prices and real wealth pass on monetary effects into the economy. Other significant transmission mechanisms look at the effects of foreign exchange and equities (Mishkin, 1996). 

Other Channels – Foreign exchange and Equity Price Channels 
In the foreign exchange channel, the effect of the Central Bank increasing money supply leads to 
 a fall in short-term nominal interest rates and similarly this affects the real interest rates. In an economy such as the US economy, the effect of a fall in short-term real interest rates means that dollar deposits become less attractive when viewed against deposits in other foreign currencies thereby leading to depreciation in the value of the dollar. The effect of this fall in value is that domestic goods become cheaper than their foreign counterparts thereby increasing net exports and therefore GDP. In essence, the reason why some open economies use fixed and not flexible exchange rates is due to the fact that a fixed exchange rate helps to equalise the domestic interest rate to the world interest rate and thus promote cheap exports whilst rendering the monetary policy ineffective. China readily comes to mind. 

Within the equity price channel, Mishkin (1996) lays emphasis on two (2) equity price channels: Tobin’s Q and wealth effects. The Tobin’s Q is the ratio of the market value of capital to the replacement cost of capital. When Q is high, companies increase investments because of low interest rates or high value of installed capital. In contrast, when Q is low, there would be decreased investment. An expansionary monetary policy can in effect lead to a high Q due to low interest rates and therefore access to more money to spend on stocks and other physical investments. A higher market value of stock will therefore result in a higher value of Q. As to the influence of wealth effects, an increase in the market value of stocks is in line with the notion that a monetary expansion of low interest rates will translate into an increase in bond prices and therefore overall increase in wealth prospects of the household. 

Financial Accelerator Effect 
In the credit channel, the assumption therefore is that constrained credit market situations give rise to the “Financial Accelerator” effect which then amplifies the effect of real or monetary shocks on the economy. Bernanke and Gertler (1989) note that, in such state, the borrowers tend to have superior information about their credit-worthiness than the lenders (Banks and other financial intermediaries) which leads to an additional premium between the cost of funds generated internally and those raised from the capital markets. This premium has been termed the “External Finance Premium”. Furthermore, they conjecture that in times of recession as witnessed in most economies in the 2007 and 2008, this premium become more pronounced due to weak balance sheets. 

The resultant effect of the financial accelerator effect is therefore is seen as reduced demand for investment activities which translates into a reduction in economic activity thereby reducing economic output (GDP). In addition, in a recession, the banks can also raise their requirements for credit supply as companies become riskier in terms of lopsidedness of liabilities over assets on their balance sheet. This in effect will limit access to credits to weaker borrowers who are the most vulnerable. The banks may not lend and even if they do, it would be at a higher interest rate. (See fig 2). 

Fig 2: Credit Channel of the financial accelerator 
Source: Adapted from Bowers, P., (2009) Lecture notes on Economics for Business Managers. 

This is the first of a two-part analysis on the relationship between the Monetary Transmission and the Oil Industry. In this instalment Lanre embarks on a review of earlier studies carried out in relation to the Oil price and its feedback with the Transmission Mechanism and the financial accelerator effect. In the next instalment he will give an insight into the 2007/2008 financial crash and its economic impacts. He will then proceed to the nexus between the monetary transmission mechanism, the financial accelerator effect alongside the impact of the financial crisis of the on the level of investment in the oil industry is investigated. For more information on this article and to view Lanre's professional profile, click here -->

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