Euro-monetary Transition

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the lagged cash to capital ratio.
Keywords:
JEL Codes: D21, D92, E22, E52
Investment, User Cost of Capital, Credit Channel, Panel Data

Firms’ investment behaviour may be affected by at least two channels of monetary
transmission – interest rate channel and the credit channel – both of which are of key
interest to this paper. The interest rate channel refers to the direct impact of interest rate
changes through the user cost of capital on firms’ investment activity. The credit channel
refers to information asymmetries and other market frictions affecting the investment
behaviour of individual firms. Information asymmetries between firms and potential
lenders with regard to the true financial situation, investment opportunities, and thus the
appropriate market value of the firm, may result in an adverse selection problem driving a
wedge between the cost of externally raised funds and the opportunity cost of internal
funds. As a result, firms may have to pay an external finance premium, which is related to
the financial situation of the firm. In general, it is expected that the more creditworthy
firms are, the lower their external finance premium will be. The existence of a credit
channel would imply that monetary policy affects not only current interest rates, but also
the size of the external finance premium via reduced current and expected future profits,
lowering equity prices and hence collateral, which in turn amplifies the monetary policy
effect on firms’ investments.
This paper fits into a growing empirical literature that aims to analyse the existence of the
credit channel. The aim of this paper is to present first empirical results on the monetary
transmission process using Luxembourg firm-level data. More specifically, we investigate
whether Luxembourg firms’ investment is sensitive to the user cost of capital, to which
extent the user costs are affected by monetary policy, as well as to ana...