28 Journal of Economic Perspectives accelerator"variables such as lagged output, sales or cash flow-have the greatest impact on spending. (For recent surveys on the determinants of spending components, see blinder and maccini. 1991. on inventories: Chirinko. 199%. on business fixed in- vestment; and Boldin, 1994, on housing. ) Further, in the relatively few cases in which evidence for a cost-of-capital effect is found, the nonneoclassical determinants of spend ing typically remain significant (for example, Boldin, 1994; Cummins, Hassett and Hubbard, 1994). Empirical studies that have tested the neoclassical model in its equi alent "Tobins q formulation have generally been no more successful Beyond the problem of weak cost-of-capital effects in estimated spending equa- tions, there is a presumption that monetary policy should have its strongest infl ence on short-term interest rates. For example, the federal funds rate, the most closely controlled interest rate, is an overnight rate. Conversely, monetary poli should have a relatively weaker impact on long-term rates, especially real long-term purchases of long-lived assets, such as housing or production equipment, which 9 rates. It is puzzling therefore, that monetary policy apparently has large effects to the extent that they are sensitive to interest rates at all-should be responsive primarily to real long-term rates These gaps in the conventional story have led a number of economists to ex- plore whether imperfect information and other"frictions"in credit markets might help explain the potency of monetary policy. Collectively, the mechanisms that have been described in this literature are known loosely as the credit channel of mon- etary transmission. In this article, we summarize our current view of the credit channel and its role inside the "black box"of monetary policy transmission We don' t think of the credit channel as a distinct, free-standing alternative to the traditional monetary transmission mechanism, but rather as a set of factors that amplify and propagate conventional interest rate effects. For this reason, the term credit channel" is something of a misnomer; the credit channel is an enhance- nent mechanism, not a truly independent or parallel channel. Moreover, this no- menclature has led some authors to focus-inappropriately, in our view-on the behavior of credit aggregates, a point that we discuss later. However, it is probably too late to change the terminology now According to the credit channel theory, the direct effects of monetary policy on interest rates are amplified by endogenous changes in the external finance premium, which is the difference in cost between funds raised externally(by issuing equity or debt) and funds generated internally(by retaining earnings). The size of the external finance premium reflects imperfections in the credit markets that drive a wedge be- tween the expected return received by lenders and the costs faced by potential bor owers.According to the credit view, " a change in monetary policy that raises or lowers open-market interest rates tends to change the external finance premium in the same direction. Because of this additional effect of policy on the extermal finance 2 Although we focus on the external finance premium in this article, it should be clear that credit market imperfections may also affect the safe real interest rate in general equilibrium(for example, Stein, 995b). In emphasizing the external finance premium, we implicitly assume that, over the time span under consideration, the Fed can set the short-term safe rate at the level that it desire28 Journal of Economic Perspectives "accelerator" variables such as lagged output, sales or cash flow-have the greatest impact on spending. (For recent surveys on the determinants of spending components, see Blinder and Maccini, 1991, on inventories; Chirinko, 1993, on business fixed in￾vestment; and Boldin, 1994, on housing.) Further, in the relatively few cases in which evidence for a cost-of-capital effect is found, the nonneoclassical determinants of spend￾ing typically remain significant (for example, Boldin, 1994; Cummins, Hassett and Hubbard, 1994). Empirical studies that have tested the neoclassical model in its equiv￾alent "Tobin's q" formulation have generally been no more successful. Beyond the problem of weak cost-of-capital effects in estimated spending equa￾tions, there is a presumption that monetary policy should have its strongest influ￾ence on short-term interest rates. For example, the federal funds rate, the most closely controlled interest rate, is an overnight rate. Conversely, monetary policy should have a relatively weaker impact on long-term rates, especially real long-term rates. It is puzzling, therefore, that monetary policy apparendly has large effects on purchases of long-lived assets, such as housing or production equipment, which to the extent that they are sensitive to interest rates at all-should be responsive primarily to real long-term rates. These gaps in the conventional story have led a number of economists to ex￾plore whether imperfect information and other "frictions" in credit markets might help explain the potency of monetary policy. Collectively, the mechanisms that have been described in this literature are known loosely as the credit channel of mon￾etary transmission. In this article, we summarize our current view of the credit channel and its role inside the "black box" of monetary policy transmission. We don't think of the credit channel as a distinct, free-standing alternative to the traditional monetary transmission mechanism, but rather as a set of factors that amplify and propagate conventional interest rate effects. For this reason, the term "credit channel" is something of a misnomer; the credit channel is an enhance￾ment mechanism, not a truly independent or parallel channel. Moreover, this no￾menclature has led some authors to focus-inappropriately, in our view-on the behavior of credit aggregates, a point that we discuss later. However, it is probably too late to change the terminology now. According to the credit channel theory, the direct effects of monetary policy on interest rates are amplified by endogenous changes in the extemnal finance premium, which is the difference in cost between funds raised externally (by issuing equity or debt) and funds generated internally (by retaining earnings).2 The size of the external finance premium reflects imperfections in the credit markets that drive a wedge, be￾tween the expected return received by lenders and the costs faced by potential bor￾rowers. According to the "credit view," a change in monetary policy that raises or lowers open-market interest rates tends to change the external finance premium in the same direction. Because of this additional effect of policy on the external finance 2 Although we focus on the external finance premium in this article, it should be clear that credit market imperfections may also affect the safe real interest rate in general equilibrium (for example, Stein, 1995b). In emphasizing the external finance premium, we implicitly assume that, over the time span under consideration, the Fed can set the short-term safe rate at the level that it desires