Ben s. bernanke and mark gertler 2 premium, the impact of monetary policy on the cost of borrowing broadly defined- and, consequently, on real spending and real activity-is magnified Why should actions taken by the central bank have any effect on the external finance premium in credit markets? In this article we describe two possible link ges. The first of these, the balance sheet channel, stresses the potential impact of changes in monetary policy on borrowers balance sheets and income statements, including variables such as borrowers' net worth, cash flow and liquid assets. The second linkage, the bank lending channel, focuses more narrowly on the possible effect of monetary policy actions on the supply of loans by depository institutions In our view, the existence of a balance sheet channel seems fairly well established e bank lending channel is more controversial, Institutional changes during the past 15 years or so have rendered the bank lending channel, at least as traditionally con- ceived, somewhat less plausible. On the other hand, certain other developments may increased the importance of bank lending in monetary transmission. In this paper we do not attempt to draw strong conclusions about the relative importance of the balance sheet and bank lending channels. Instead, we try to make the case for the broader view that allowing for a credit channel of some type is important for under- standing the response of the economy to changes in monetary policy How the Economy Responds to Monetary Policy Shocks: Facts and Puzzles To set the stage for our discussion of how monetary policy works, we first fill in some of the details about what happens in the economy after a change in mon etary policy (a tightening, say)occurs. We do so by extending recent empirical work on the effects of monetary policy to consider its impact on some of GDP. We emphasize four basic facts about the response of the economy to mon- etary policy shocks Fact I: Although an unanticipated tightening in monetary policy typically has only transitory effects on interest rates, a monetary tightening is followed by sustained declines in real GDP and the price level Fact 2: Final demand absorbs the initial impact of a monetary tightening, falling relatively quickly after a change in policy. Production follows final demand downward, but only with a lag, implying that inventory stocks rise in the short run Ultimately, however, inventories decline, and inventory disinvestment accounts for a large portion of the decline in GDP. Fact 3: The earliest and sharpest declines in final demand occur in residential investment, with spending on consumer goods(including both durables and non- durables)close behind nkages have been extensively discussed in the literature. Surveys of related material include others) Bernanke (1993a), Kashyap and Stein(1994), Hubbard(1994)and Bernanke, Gertler arist(forthcoming)Ben S. Bernanke and Mark Gertler 29 premium, the impact of monetary policy on the cost of borrowing broadly defined and, consequently, on real spending and real activity-is magnified. Why should actions taken by the central bank have any effect on the external finance premium in credit markets? In this article we describe two possible link￾ages.3 The first of these, the balance sheet channel, stresses the potential impact of changes in monetary policy on borrowers' balance sheets and income statements, including variables such as borrowers' net worth, cash flow and liquid assets. The second linkage, the bank lending channel, focuses more narrowly on the possible effect of monetary policy actions on the supply of loans by depository institutions. In our view, the existence of a balance sheet channel seems fairly well established. The bank lending channel is more controversial. Institutional changes during the past 15 years or so have rendered the bank lending channel, at least as traditionally con￾ceived, somewhat less plausible. On the other hand, certain other developments may have increased the importance of bank lending in monetary transmission. In this paper we do not attempt to draw strong conclusions about the relative importance of the balance sheet and bank lending channels. Instead, we try to make the case for the broader view that allowing for a credit channel of some type is important for under￾standing the response of the economy to changes in monetary policy. How the Economy Responds to Monetary Policy Shocks: Facts and Puzzles To set the stage for our discussion of how monetary policy works, we first fill in some of the details about what happens in the economy after a change in mon￾etary policy (a tightening, say) occurs. We do so by extending recent empirical work on the effects of monetary policy to consider its impact on some key components of GDP. We emphasize four basic facts about the response of the economy to mon￾etary policy shocks. Fact 1: Although an unanticipated tightening in monetary policy typically has only transitory effects on interest rates, a monetary tightening is followed by sustained declines in real GDP and the price level. Fact 2: Final demand absorbs the initial impact of a monetary tightening, falling relatively quickly after a change in policy. Production follows final demand downward, but only with a lag, implying that inventory stocks rise in the short run. Ultimately, however, inventories decline, and inventory disinvestment accounts for a large portion of the decline in GDP. Fact 3: The earliest and sharpest declines in final demand occur in residential investment, with spending on consumer goods (including both durables and non￾durables) close behind. 3Both linkages have been extensively discussed in the literature. Surveys of related material include (among others) Bernanke (1993a), Kashyap and Stein (1994), Hubbard (1994) and Bernanke, Gertler and Gilchrist (forthcoming)