This paper is a theoretical study of the transmission mechanism of monetary policy in the presence of an endogenous role of bank capital. The basic framework is a standard Dynamic New Keynesian model with price stickiness modified so as firms as well as banks face endogenous financial frictions in obtaining external funds from their respective debtors. This implies that an external financial premium exists, thereby motivating the endogenous role of entrepreneurial net worth and bank capital in the model. In the terminology of Van den Heuvel (2001), the model exhibits the unconventional ‘bank capital’ channel of monetary policy. The simulation result highlights a financial accelerator effect in that endogenous evolution of bank capital, together with that of entrepreneurial net worth, operate to amplify and propagate the effect of a monetary shock in the macroeconomy.
