understand the identifying restrictions underlying the econometric approach, which has
been followed in the empirical literature to uncover the lending channel and, on the other
hand, will enable us to define an alternative testing strategy. The model draws heavily on
Bernanke and Blinder (1988), but it departs from their model in the way money supply is
modelled and monetary policy is implemented.
Let us assume that we have an economy with three different agents or sectors and
four assets. The agents are the non-banking sector, the banking sector and the central
bank. The central bank sets monetary policy either by changing the reserve requirement
ratio, setting the discount interest rate or controlling the bond rate by conducting open
market operations. In either case banks react by changing the amount of reserves as well
as the other items of their balance sheets. In our model we explicitly assume that the
central bank sets monetary policy by changing the discount rate or the money market rate,
but the model can easily be adapted to deal with other monetary policy instruments.
The four assets are deposits held by the private sector with banks, loans granted by
banks to the private sector, reserves held by banks for legal and liquidity reasons and
bonds held both by banks for liquidity reasons and by the non-financial sector for liquidity
and or portfolio reasons.
For the money market we assume a conventional LM curve. The demand for money
(in the form of deposits held with a typical bank) by the non-monetary sector is the
conventional money demand function
ln(D/P)td =β0+β1lnyt+β2πt+β3it
(+) (-) (-)
(3.1)
where Dt stands for the nominal deposits held by the private sector at a typical bank, Pt
the price level, yt a scale variable (for instance real GDP), πt the inflation rate and it
the interest rate on bonds. Below each coefficient in equation (3.1) is the corresponding
expected sign according to the conventional economic theory2.
We write the (real) money supply as
2
For ease of presentation we have assumed in equation (3.1) that deposits depend on a single interest
rate. Because Dt includes order as well as time deposits, a more realistic money demand function should also
include the own rate on time deposits or a weighted average of the interest rates on total deposits. However in
this case we would have also to explicitly model the bond market, which would make the solution of the
model somewhat cumbersome, without changing the main points we want to make.