34 Journal of Economic Perspectives the policy effect. We and many other researchers have found that the real economy is powerfully affected by monetary policy innovations that induce relatively small movements in open-market interest rates. But as we discussed earlier, empirical studies have not typically found commensurately strong cost-of-capital effects on the various components of private spending Second is the issue of timing. As shown by Figure 1, the interest-rate spike associated with an unanticipated monetary tightening is largely transitory; the fed eral funds rate is virtually back to trend at eight to nine months after the shock. Yet some important components of spending do not begin to react until after most of the interest-rate effect is past. For example, the bulk of the response of business fixed investment occurs during the period between six and 24 months after the shock(Figure 3). Inventories actually rise during the first three to four months after a monetary tightening; they begin to decline only in the period during which interest rates are falling sharply back to trend(Figure 2). The poor correspondence in timing between changes in interest rates and movements in some components of spending observed in Figures 1-3 no doubt helps to explain why robust effects of interest rates on spending have been hard to pin down empirically a third issue is the composition of the spending effects Because monetary policy as its most direct effects on short-term rates. it would seem that it should have its most significant impact on spending on assets with shorter lives-some types of nventories and consumer durables, for example. Yet the most rapid (and in per- centage terms, by far the strongest) effect of monetary policy is on residential in- vestment(Figure 3). This finding is puzzling because residential investments are typically very long-lived and thus(according to the conventional view) should be most sensitive to long-term real interest rates, not the short-term rates most directly nfluenced by the Fed. At the same time the other major type of long-lived invest ment, business structures investment, does not seem to be much affected by mon etary policy actions. It is not immediately obvious why residential and business struc- tures investment behavior should differ in this way The Credit Channel of Monetary Transmission We have argued that it is difficult to explain the magnitude, timing and com- position of the economys response to monetary policy shocks solely in terms of conventional interest-rate(neoclassical cost-of-capital)effects. The mechanisms col- lectively known as the credit channel help to fill in the gaps in the traditional story. Underlying our conception of the credit channel is the following basic premise whenever frictions-such as imperfect information or costly enforcement of Adjustment costs are an alternative potential explanation of the lagged response of investment terest rates.h most attempts to fit neoclassical investment equations with adjustment costs have estimated those costs to be implausibly large. If adjustment costs are important, there remains the que tion of why managers should respond at all to interest-rate fluctuations that they should expect to be34 Journal of Economic Perspectives the policy effect. We and many other researchers have found that the real economy is powerfully affected by monetary policy innovations that induce relatively small movements in open-market interest rates. But as we discussed earlier, empirical studies have not typically found commensurately strong cost-of-capital effects on the various components of private spending. Second is the issue of timing. As shown by Figure 1, the interest-rate spike associated with an unanticipated monetary tightening is largely transitory; the fed￾eral funds rate is virtually back to trend at eight to nine months after the shock. Yet some important components of spending do not begin to react until after most of the interest-rate effect is past. For example, the bulk of the response of business fixed investment occurs during the period between six and 24 months after the shock (Figure 3).9 Inventories actually rise during the first three to four months after a monetary tightening; they begin to decline only in the period during which interest rates are falling sharply back to trend (Figure 2). The poor correspondence in timing between changes in interest rates and movements in some components of spending observed in Figures 1-3 no doubt helps to explain why robust effects of interest rates on spending have been hard to pin down empirically. A third issue is the composition of the spending effects. Because monetary policy has its most direct effects on short-term rates, it would seem that it should have its most significant impact on spending on assets with shorter lives-some types of inventories and consumer durables, for example. Yet the most rapid (and in per￾centage terms, by far the strongest) effect of monetary policy is on residential in￾vestment (Figure 3). This finding is puzzling because residential investments are typically very long-lived and thus (according to the conventional view) should be most sensitive to long-term real interest rates, not the short-term rates most directly influenced by the Fed. At the same time, the other major type of long-lived invest￾ment, business structures investment, does not seem to be much affected by mon￾etary policy actions. It is not immediately obvious why residential and business struc￾tures investment behavior should differ in this way. The Credit Channel of Monetary Transmission We have argued that it is difficult to explain the magnitude, timing and com￾position of the economy's response to monetary policy shocks solely in terms of conventional interest-rate (neoclassical cost-of-capital) effects. The mechanisms col￾lectively known as the credit channel help to fill in the gaps in the traditional story. Underlying our conception of the credit channel is the following basic premise: whenever frictions-such as imperfect information or costly enforcement of 9Adjustment costs are an alternative potential explanation of the lagged response of investment to interest rates. However, most attempts to fit neoclassical investment equations with adjustment costs have estimated those costs to be implausibly large. If adjustment costs are important, there remains the ques￾tion of why managers should respond at all to interest-rate fluctuations that they should expect to be temporary