be satisfied for a lending channel to operate are: (a) banks cannot shield their loan
portfolios from changes in monetary policy; and (b) borrowers cannot fully insulate their
real spending from changes in the availability of bank credit.
The first of these conditions tells us that banks are not able to completely offset the
decrease in deposits brought about by monetary policy shocks, by resorting to alternative
sources of funds (at least not without incurring in increasing costs). Because of the extra
premium that banks have to pay to bring in alternative external funds, banks will make
fewer loans after the fall in reserves brought about by monetary policy. Of course, it is
expected that banks hedge against changes in monetary policy, by holding securities as a
buffer against a reserve outflow. But such buffer is not expected to fully offset the effects
of a contractionary monetary policy, as buffer stocks are costly for banks (in terms of
interest foregone).
The second condition tells us that some spending, which is financed with bank loans,
will not occur if banks cut the loans, else the real consequences of the credit channel will
be null.
In summary, while the traditional theory emphasises the households’ preferences
between money and other liquid assets (bonds) the credit view argues that the banking
behaviour is also very important to the transmission of monetary policy1.
3. An IS/LM model with the lending channel
In this section we introduce a standard IS/LM model for analysing the monetary
transmission mechanism at the bank level. On the one hand, the model will help us to
1 Some authors (for instance, Bernanke and Gertler (1995)) distinguish between “credit channel” and
“bank-lending channel”. The transmission channel which we indistinctly labelled in this section as the
“lending or credit channel”, is referred to by these authors as the “bank-lending channel” and they use the
expression “credit channel” in a broader sense, which includes both the bank-lending channel and the so-
called “balance-sheet channel”. This latter channel reflects the influence of monetary policy on the net worth
and other determinants of the financial position of potential borrowers. In this paper we do not make such a
distinction, and in the following sections the strictly speaking bank-lending channel is referred to indistinctly
both as the credit channel or the bank-lending channel. Readers interested in a detailed analysis of the
theoretical underpinnings of the bank lending channel are referred, for instance, to Kashyap and Stein (1998),
Valery Ramey (1993), Bernanke and Gertler (1995) or Trautwein (2000), who present very good discussions
of some of the micro-foundations that underlie the bank lending channel theory of monetary policy
transmission mechanism.