α₁ ≠ 0 in (3.4) captures the idea that banks cannot shield their loan portfolios from
changes in monetary policy, i.e., from changes in deposits brought about by monetary
policy and plays a central role in our analysis. Also important is the coefficient α₃ as it
determines the slope of the supply curve.

Equilibrium in the credit market will determine the equilibrium loan interest rate, l_t ,
and the equilibrium quantity of real bank credit, ln(C / P)_t , for given y_t , ln(D/P)_t ,
π_t and i_t . Finally, plugging the equilibrium values for i_t and ln(D/ P)_t obtained from
the money market into the equilibrium equations for l_t and ln(C / P)_t we find the
reduced form equations for l_t and ln(C / P)_t as a function of the exogenous variables of
the model: ln(R/ P)_t, lny_t, π_t and r_t .

As we saw in the previous section the lending channel operates through shifts in the
loan supply curve in response to changes in monetary policy. To see how it operates in our
model, let us assume, for instance, that the central bank increases the discount rate, r_t .
This will reduce the equilibrium quantity of money in the economy, i.e., deposits in our
model, through the interaction between money supply and money demand schedules (3.1)
and (3.2). In turn, the drop in deposits held by the private sector with the banks shifts the
loan supply schedule upwards if α₁ > 0 in (3.4). It is this additional transmission
mechanism - the upward shift in supply of loans - which is known in the literature as the
bank-lending channel. As mentioned above, at the micro level the existence of a lending
channel rests on the assumption that banks cannot easily replace lost deposits with other
sources of funds, such as certificates of deposits or new equity issues, or by selling
securities. Otherwise, we would expect α₁ not to be significantly different from zero. Of
course for the upward shift to occur the supply curve cannot be horizontal. In other words
we need the additional assumption that α₃ in (3.4) is finite.

To test the existence of the credit channel and evaluate its importance we need to
estimate α₁ and α₃ in equation (3.4), and test whether α₁ is significantly different from
zero and positive and that α₃ is not very large. The credit channel is the more important
the larger α₁ and the smaller α₃ . In empirical terms, this upward shift in the loan supply
needs to be clearly distinguished from the simultaneously expected inward shift in loan
demand (the so-called money view). This is the well-known identification problem, which
we address in the following section.

4. What are the difficulties with the reduced form approach?

So far, in the literature, the bulk of tests for the existence of a credit channel of monetary
policy has been carried out by estimating reduced form equations for bank credit. Most of

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