Introduction

This paper investigates whether the effects of monetary policy on economic activity in the euro area depend on the state of the economy. At least two strands of the literature predict that monetary policy is more effective in a recession than during a boom.

The first class of theories is based on credit market imperfections. In these models, asymmetric information between borrowers and lenders gives rise to agency costs. These agency costs are reflected in an external finance premium, which typically depends on the net worth of the borrower. A borrower with higher net worth is able to post more collateral and can thereby reduce its cost of external financing.

As emphasised by Bernanke and Gertler (1989), the dependence of the external finance premium on the net worth of borrowers creates a ‘financial accelerator’ propagation mechanism. For example, when an economy is hit by a recession, the net worth of firms will typically fall. This decline leads to an increase in the cost of external financing, which in turn may aggravate the effects of the initial shock. During an expansion, firms can largely finance themselves with retained earnings. Moreover, because their balance sheets are strong, the external finance premium is likely to be relatively low. As a result, monetary policy changes have only a limited impact on this premium.