This paper is organised as follows. Section 2 briefly reviews the money and credit
views of the monetary transmission mechanism. Section 3 introduces an IS/LM model of
the monetary policy transmission mechanism in order to clarify the restrictions, which
underlie the conventional reduced form approach and motivate the alternative approach
suggested in this paper. Section 4 discusses the main restrictions underlying the reduced
form approach. Section 5 describes the “structural approach” followed in this paper and
discusses the identification problem and the econometric approach to be implemented in
the empirical section. Section 6 briefly characterises the Portuguese banking sector and
the changes it underwent during the nineties. Section 7 reports the empirical results for
Portugal and section 8 summarises the main conclusions.

2. The bank lending channel

The classical textbook approach to monetary policy focus on how the central bank’s
actions affect the households and firms portfolios, by assuming the existence of only two
classes of assets: money and other assets (usually simply labelled as “bonds”). Under this
approach to the monetary policy transmission mechanism, known as the money view or
money channel of monetary policy, the central bank, by manipulating banks’ reserves is
assumed to be able to control the quantity of money (deposits, with the banks) thereby
affecting the nominal interest rate (the relative price of money and bonds). In turn,
changes in nominal interest rate are expected to translate into changes of the real interest
rate (prices are sticky in the short run) thus affecting the economy either through
aggregate demand (IS/LM framework) or/and through aggregate supply (Christiano and
Eichenbaum (1995) framework). Thus, according to the money view, the monetary
transmission mechanism operates through the liability side of banks’ balance sheets.

There are two basic necessary conditions for the money channel to work: (a) banks
cannot perfectly shield transaction balances (deposits) from changes in reserves; and (b)
there are no close substitutes for money in the conduct of transactions in the economy.

The point of departure of the credit view is the rejection of the notion that all non-
monetary assets are perfect substitutes. In particular, it is assumed that internal funds,
bank loans and other sources of financing are imperfect substitutes for firms. According to
the credit view of the monetary policy transmission mechanism, monetary policy works
by affecting bank assets (loans) in addition to banks’ liabilities (deposits). The key point is
that monetary policy besides shifting the supply of deposits also shifts the supply of bank
loans. In this context, the crucial response of banks to monetary policy is their lending
response and not their role as deposit creators. The two key necessary conditions that must

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