Inside the black Box: The Credit Channel of Monetary Policy Transmission 35 contracts-interfere with the smooth functioning of financial markets, we expect to observe a wedge between the cost of funds raised externally (for example, hrough the issuance of imperfectly collateralized debt) and the opportunity cost of internal funds. This wedge, which we call the external finance premium, reflects the deadweight costs associated with the principal-agent problem that typically ex- ists between lenders and borrowers. Among the factors reflected in the external finance premium are the lender's expected costs of evaluation, monitoring and collection; the"lemons"premium that results from the fact that the borrower inevitably has better information about its prospects than does the lender; and the costs of distortions in the borrower's behavior that stem from moral hazard or from restrictions in the contract intended to contain moral hazard (for example, restric- tive covenants or collateral requirements According to advocates of the credit channel, monetary policy affects not only the general level of interest rates, but also the size of the extermal finance premium. This complementary movement in the extemal finance premium may help explain the strength, timing and composition of monetary policy effects better than is possible by reference to interest rates alone. Two mechanisms have been suggested to explain the link between monetary policy actions and the extermal finance premium: the balance sheet channel(sometimes called the net worth channel) and the bank lending chan- nel. In describing how these channels work, in the rest of this section, we focus on the behavior of firms. SI be extended to consumer behavior, like spending on housing and consumer durable The balance sheet Channel The balance sheet channel is based on the theoretical prediction that the ex ternal finance premium facing a borrower should depend on borrower's financial position. In particular, the greater is the borrower's net worth-defined operation- finance premium should be. Intuitively, a stronger hina the lower the external ally as the sum of her liquid assets and marketable collateral-t ion(greater net worth)enables a borrower to reduce her potential conflict of interest with the lender, either by self-financing a greater share of her investment project or pur chase or by offering more collateral to guarantee the liabilities she does issue. This asic insight underlies many real-world financial arrangements, such as the require- ment that borrowers meet certain financial ratios, that they post collateral andyor that they make down payments Since borrowers' financial positions affect the extermal finance premium, and thus the overall terms of credit that they face, fluctuations in the quality of borrowe balance sheets similarly should affect their investment and spending decisions.An extensive theoretical literature has exploited this idea to argue that endogenous pro- cyclical movements in borrower balance sheets can amplify and propagate business cycles, a phenomenon that has been referred to as the"financial accelerator. This approach has been supported by a wide range of empirical work linking balance sheet and cash flow variables to firms' decisions concerning fixed investment, inventories and other factor demands, and to household purchases of durables and housing. Ber- nanke, Gertler and Gilchrist(forthcoming) offer a discussion and referencesInside the Black Box: The Credit Channel of Monetary Policy Transmission 35 contracts-interfere with the smooth functioning of financial markets, we expect to observe a wedge between the cost of funds raised externally (for example, through the issuance of imperfectly collateralized debt) and the opportunity cost of internal funds. This wedge, which we call the external finance premium, reflects the deadweight costs associated with the principal-agent problem that typically ex￾ists between lenders and borrowers. Among the factors reflected in the external finance premium are the lender's expected costs of evaluation, monitoring and collection; the "lemons" premium that results from the fact that the borrower inevitably has better information about its prospects than does the lender; and the costs of distortions in the borrower's behavior that stem from moral hazard or from restrictions in the contract intended to contain moral hazard (for example, restric￾tive covenants or collateral requirements). According to advocates of the credit channel, monetary policy affects not only the general level of interest rates, but also the size of the external finance premium. This complementary movement in the external finance premium may help explain the strength, timing and composition of monetary policy effects better than is possible by reference to interest rates alone. Two mechanisms have been suggested to explain the link between monetary policy actions and the external finance premium: the balance sheet channel (sometimes called the net worth channel) and the bank lending chan￾nel. In describing how these channels work, in the rest of this section, we focus on the behavior of firms. Subsequently, we will discuss how the analysis may be extended to consumer behavior, like spending on housing and consumer durables. The Balance Sheet Channel The balance sheet channel is based on the theoretical prediction that the ex￾ternal finance premium facing a borrower should depend on borrower's financial position. In particular, the greater is the borrower's net worth-defined operation￾ally as the sum of her liquid assets and marketable collateral-the lower the external finance premium should be. Intuitively, a stronger financial position (greater net worth) enables a borrower to reduce her potential conflict of interest with the lender, either by self-financing a greater share of her investment project or pur￾chase or by offering more collateral to guarantee the liabilities she does issue. This basic insight underlies many real-world financial arrangements, such as the require￾ment that borrowers meet certain financial ratios, that they post collateral and/or that they make down payments. Since borrowers' financial positions affect the external finance premium, and thus the overall terms of credit that they face, fluctuations in the quality of borrowers' balance sheets similarly should affect their investment and spending decisions. An extensive theoretical literature has exploited this idea to argue that endogenous pro￾cyclical movements in borrower balance sheets can amplify and propagate business cycles, a phenomenon that has been referred to as the "financial accelerator." This approach has been supported by a wide range of empirical work linking balance sheet and cash flow variables to firms' decisions concerning fixed investment, inventories and other factor demands, and to household purchases of durables and housing. Ber￾nanke, Gertler and Gilchrist (forthcoming) offer a discussion and references