Understanding The Fluctuations Of Trade Credit Terms In Reaction To Interest Rate Adjustments
Dr. Emily C. Lee
Department of Finance, Ryerson University, Toronto, Canada
Dr. Abdullah M. Rahman
Department of Finance, Ryerson University, Toronto, Canada
Abstract
This study investigates the impact of trade credit on the credit channel of monetary policy transmission. Despite the growing interest in monetary policy effectiveness, a comprehensive theoretical model explaining the empirical observation that trade credit mitigates the effects of central bank actions has been lacking. In this paper, we introduce a partial equilibrium model incorporating third-degree price discrimination with menu costs. Our key finding suggests that, in low-inflation periods, the increase in net present value (NPV) resulting from optimizing credit terms and product prices is insufficient to outweigh even minimal menu costs associated with short-term interest rate changes. As a result, credit terms and product prices remain stable over time. This outcome aligns with empirical evidence from Ng, Smith, and Smith (1999) and Mateut (2005) and provides a plausible explanation for the Meltzer (1960) hypothesis, which posits that trade credit fluctuates less than bank credit in the credit channel transmission of monetary policy. Furthermore, we draw parallels between this phenomenon and exchange rate pass-throughs and discuss the effectiveness of monetary easing during a pandemic