The Transmission Mechanism and the Channels of Monetary Policy

@ Free Notes by Dr. Azali Mohamed 33.2.1 The Money ViewThe money view places emphasis on the changes in the monetary aggregate affecting theoutput via interest rate channel. This view has been a standard feature in the traditionalKeynesian model. The mechanism can be traced by using the following schematic diagram(Mishkin, 1995):Mfl r› Ifl Yfl ,This diagram states that a contractionary monetary policy (M) leads to a rise in real interestrate (r), which raises the cost of capital, thereby causing a decline in investment goods (I).Further, this leads to a decline in aggregate demand and hence, a fall in output (Y).Generally, this argument can be presented in a simple IS-LM framework. The frameworkfocuses on the equilibrium position between the demand for and supply of money todetermine the rate of interest. This in turn provides the link to real spending and investment.Let the monetary equilibrium and the LM curve be depicted by equations (3.1) - (3.3),respectively 3 ;money demand M d = f (y,r); f 1 ’>0, f 2 ’

@ Free Notes by Dr. Azali Mohamed 5From (3.9) a change in the money supply clearly affects the level of income through theparameters a 1 , a 2 , b 1 , f 1 , and f 2 which are all slopes of the IS-LM curves. Thus, we canhave the money multiplier in the form of the coefficient on ∆M:(3.10)1∆ y =∆ M⎛ a1 f⎜ 2 ⎞⎟ + f⎝ b − 11 a2⎠Based on equation (3.10) it is clear that the interest rate channel or the cost of capitalchannel operates through the following schematic diagram:f 2 : ( ∆M ⇒ ∆r), b 1 :(∆r ⇒ ∆I) and a 1 :(∆I ⇒ ∆y) with f 1 :(∆y ⇒ ∆M d ) acting as afeedback effect.Considering the money view, obviously there are two implicit assumptions in the model. Thefirst is that all non-money assets are lumped together into bonds. Therefore, by usingWalrasian Law the bond market is in equilibrium, implying that the credit market is largelyignored in the standard IS-LM model and is restricted to a single portfolio equation(Brunner and Meltzer, 1988). There are two implications that can be drawn from thisassumption. First, it makes no difference whether banks hold loans or governmentsecurities as their assets. Second, it makes no difference whether borrowers obtain creditfrom auction markets (the commercial paper market and the corporate bond market) orfrom the banks (Yang, 1994).

@ Free Notes by Dr. Azali Mohamed 6The second assumption of the money view is that all markets are perfect. All of theborrowers are homogenous from the view point of the lenders. Thus, the banks cannotdiscriminate between the characteristics of different borrowers. Hence, price is the onlyfactor to clear the markets or to equilibrate the markets. Consequently, the presence ofendogenous credit rationing is also ruled out by the second assumption (Bernanke andBlinder, 1988).3.2.2 The Credit ViewThe proponents of the credit view claim that the credit market has been simply ignored bythe money view. Therefore, in addition to the money supply, bank credit is also important inaffecting the aggregate spending level. Bernanke and Gertler (1995) describe two possiblelinkages of the credit channel theory. The first one is the balance-sheet channel which placesemphasis on the impact of changes in monetary policy on the borrower's balance-sheet.The second linkage is the bank lending channel which focuses on the possible effect ofmonetary policy actions on the supply of loans by the banking system (Walsh and Wilcox,1995; Bernanke, 1993a and 1993b).Schematically, the monetary policy effects can be summarised as follows:M fl bank deposit fl bank loans fl I fl Y fl ,Thus, contractionary monetary policy leads to a fall in bank reserves and bank deposits,subsequently this results in a decline in bank loans, in turn leading to a decline in investmentspending and a fall in output.

@ Free Notes by Dr. Azali Mohamed 7To facilitate the schematic diagram above, let us consider a variant of the IS-LM model,based on the framework set out by Bernanke and Blinder (1988). Their model allows rolesfor both “credit” (bank loans) and money rather than money-only as in the traditional IS-LM framework. An explicit assumption made regarding this model is that loans and otherauction-market credit (“bonds”) are viewed as imperfect substitutes, hence, allowing themodel to include the credit and bonds market in addition to the money market 4 . By doingso, the borrowers and lenders may choose between bonds and loans according to theinterest rates on the two credit instruments. By setting up this particular assumption, the LMcurve is then derived from a set of portfolio-balance conditions on the two-asset world:money and credit (“bonds”). To derive the credit curve or “commodities and credit” (CC)curve, first, let the demand for loans be:- + +dL = L i y( ρ , , )(3.11)where ρ is the interest rate on loans, i is the interest rate on bonds, y is the income tocapture the transactional demand for credit, and the signs indicate the relationship of eachvariable with respect to the loans demand. Second, the loan supply function is derived froma simplified bank balance sheet as follows:assetsreserves (R)bonds (B b )loans (L s )liabilitiesdeposits (D)4 Karl Brunner and Allan Meltzer (1972, 1988) also develop similar models. An application on the UKdata using a variant of the Brunner and Meltzer model can be found in Kent Matthews and ChrisIoannidis (1992).

@ Free Notes by Dr. Azali Mohamed 8where R= σD + E; σ is the required reserves ratio, and E is the excess reserves. Thusthe bank’s adding-up constraint is: B b + L s + E = D (1-σ ). Therefore the loans supplyfunction is as follows:+ī σ (3.12)sL = l(r, ) D(1 - )with a similar equation for B b and E. The clearing condition for the loan market is:L d = L s (3.13)L( ρ ,i, y) = λ( ρ,i) D(1 - σ)(3.14)The money market is described by a conventional LM curve. Banks hold excess reservesequal to ε(i)D(1 - σ). The supply of deposits is equal to bank reserves, R, times themoney multiplierm = m(i).R; (3.15)where m(i) = [1/ε(1-σ)+σ] 5 .The demand for deposits isD d += D( i, y)(3.16)By using equations (3.15) and (3.16), (D = m(i)R) to replace D on the right side of theequation (3.14), we haveL = λ[ ρ, i] m( i) R( 1 - ρ)(3.17)

@ Free Notes by Dr. Azali Mohamed 9Taking the total differentiation on (3.17)withdL = λ R( 1- σ) midi + m( i) R( 1- σ)( λρdρ + λ idi) + λm( 1-σ)dR (3.18)m i > 0 ; λ ρ > 0; λ i > 0.Next, using total differentiation to solve the left hand side of equation (3.14), we havedL = Lρdρ + Lidi + Lydy(3.19)withL ρ < 0;L i > 0;L y > 0.Equating equations (3.18) and (3.19), then rearranging to solve for ρ as a function of i, y,and R; we have 6Lρ- m( i) R( 1- σ) λ ρ) dρ = λR( 1- σ) mi + m( i) R( 1- σ) λi - Li) di + (-Ly)dy+ mλm( 1 - σ)dR(3.20)Thus, the loan rate that clears the loan market can be stated as follows:ρ =+ + -Φ( i, y, R )(3.21)5 −Is solved as follows: m ≡ D / ( E + RR ) ; ∴m ≡ D / [ ε( D)( 1 − σ) + σD];∴ m( i) = [ ε( i)( 1− σ) + σ) ] 16 To get equation (4) of Bernanke and Blinder (1988;p.436).

@ Free Notes by Dr. Azali Mohamed 10Equation (3.21) shows that the interest rate on loans is positively related to interest rateon bonds and income, but inversely related to bank reserves. To solve for the aggregatedemand curve, Bernanke and Blinder (1988) use the following generic IS curve:y= Y( i, ρ )(3.22)and then by substituting equation (3.21) into (3.22), we gety = Y( i, Φ { i, y, R}),(3.23)the so-called “commodities and credit” (CC) curve in Bernanke and Blinder’s term. Figure3.1 shows both the CC and LM curves in a (i,y) space.iLMCCFigure 3.1 The Commodities-Credit (CC) and LM CurvesY

@ Free Notes by Dr. Azali Mohamed 11As discussed by Bernanke and Blinder (1988; p. 436), the CC curve 7 is negativelysloped like an IS curve but it is shifted by monetary policy 8 , R, and by credit shock thataffects either the loans demand function, L(.) or the loans supply function, λ(.).There is one disadvantage if one wants to apply this framework in a developing country'scontext. The model assumes that the loan market is always in equilibrium. This scenariomay not be true in the context of developing countries simply due to heavy governmentintervention in the loan market during the pre-liberalisation period i.e. interest-rate ceilingsand quantitative credit controls. Thus, it could be possible for the transmission mechanismprocess to exist through the credit rationing channel. Further discussion on the creditrationing channel is presented in Section 3.4.7 The CC curve reduces to the IS curve if loans and bonds are assumed to be perfect substitutes eitherto borrowers (Lρ →-∞) or to lenders (λρ→∞) or if commodity demand is insensitive to the loan rate(Yρ=0). (Ibid; p. 436)8 Graphically, the ambiguity arises because an increase in R shifts both the CC and LM curves outward.Economically, the credit channel makes monetary policy more expansionary than the IS/LM andtherefore raises the transaction demand for money by more than in the conventional model. (Ibid; p.437).

@ Free Notes by Dr. Azali Mohamed 123.3 The Development of, and Empirical Evidence Relating To the Credit andthe Money ChannelsA summary of the empirical findings of the previous studies conducted in this area ispresented in Tables 3.1 and 3.2. Tables 3.1 summarises the empirical evidence from thedeveloped countries, while Table 3.2 highlights the empirical evidence from the developingcountries. Empirical evidence from the developed countries available so far has providedsome support to the credit as well as the money channels hypothesis. However, theevidence for the developing countries is somewhat blurred.3.3.1 Evidence from the Industrialised CountriesTable 3.1 summarises the empirical evidence using the data set on most of the industrialisedcountries. Interestingly, most of these studies support the importance of the money as wellas the credit/bank lending channel in the transmission mechanism process (Bernanke (1986);Bernanke and Blinder (1988); Bernanke and Blinder (1992); Kashyap, Stein, and Wilcox(1993); Walsh and Wilcox (1995); and Oliner and Rudebush (1995)); amongst others.These studies have focused on the relationship between aggregate income, commercial bankloans, money stock, interest rates, and money indicators in the USA. For exampleBernanke (1986) used the contemporaneous structural vector autoregression approach(SVAR) and imposed covariance restrictions to gain identification. The credit variable usedby Bernanke is the sum of the commercial bank loans extended by the intermediaries.

@ Free Notes by Dr. Azali Mohamed 13Another study by Bernanke and Blinder (1988) which employed an extended version ofthe IS-LM model and incorporated the sum of borrowing by households and businesssectors as a credit variable, found that the money shocks became much more importantrelative to credit-demand shocks in the 1980’s. However there is no strong evidence toreject the role of credit demand, and thus warrant a symmetric treatment on money andcredit. In their model, Bernanke and Blinder (1988) have assumed imperfect substitutabilitybetween money, bonds and loans, thus allowing both the borrowers and lenders to choosebetween bonds and loans according to the interest rates on the two credit instruments, i.e.interest rates on loans and interest rates on bonds.Unfortunately, focusing alone on commercial bank loans still does not resolve the issue. Forexample, a recent study by Romer and Romer (1990) rejects the role of bank loans as apart of the transmission mechanism process in the USA. Romer and Romer (1990) employsix ‘episodes’ 9 of restrictive monetary policy which the Federal Reserve appears to havedeliberately used in an attempt to reduce the inflation rate during an economic slowdown.They argue that the purpose of using these ‘episodes’ as indicators of monetary policy is toovercome a difficulty in finding the legitimate monetary policy proxy to truly represent theFed’s actions 10 . The estimates of the forecast errors on both the money supply and bankloans show that the effect of loans’ forecast errors is smaller than the forecast errors ofmoney supply, therefore indicating that the money channel transmits more information to thereal sector than the credit channel does.9 The series of episodes were summarised in Table 3.1.10 Most studies in the USA use the federal funds rate as a monetary policy indicator. See, for example,Bernanke and Blider (1992) and other studies summarised in Table 3.1.

@ Free Notes by Dr. Azali Mohamed 14However, Yang (1994) criticised the Romer and Romer’s (1990) finding. Yang (1994)argues that, first, Romer and Romer (1990) have only tested the monetary policy during theperiod of tightening and not in the case of easing. Thus, the comprehensiveness of usingRomer ‘episode’ as a proxy for monetary policy is questionable. The second critique is thata strong tightening of monetary policy may cause a greater decline in the money supply thanin the credit supply. If this is the case in reality, then Romer and Romer (1990) may havedrawn an incorrect conclusion.However, the study by Gertler and Gilchrist (1995) reconfirm the evidence found by Romerand Romer (1990). Gertler and Gilchrist argue that the bank credit is more likely to bedriven by demand factors than by monetary policy because the decline in bank credit growthlags behind the decline in money growth. Similar criticism was made by Cecchetti (1995)on the Wash and Wilcox (1995) paper.Further investigation by Bernanke and Blinder (1992) obtained similar evidence to theirearlier study in 1988. By using innovation in 3-month Treasury Bill rate to captureexogenous shifts in monetary policy, they found that the decline in bank loans following amonetary policy tightening represents the credit channel. In consequence, the loan supply isrestricted via a bank lending channel. Thus, they interpret this latter evidence as consistentwith the credit view.The previous studies also show that the presence of the credit channel is not only through thebank’s balance sheet but also through the broad credit aggregate, i.e. total domestic

@ Free Notes by Dr. Azali Mohamed 15nonfinancial debt, total debt and total credit. See, for example, Bernanke (1983),Fackler (1990), and Fackler and Rogers (1993), amongst others. In order to probe theusefulness of the broad credit aggregate, Bernanke (1983) utilised the total net credit (whichis the aggregate outstanding indebtness of all US non financial borrowers) in addition tooutput (GNP), using the US historical data from 1959 to 1980. The results show that totalnet credit is a better predictor of output than monetary aggregates (M1, M2, M3, and themonetary base). This finding has been reinforced by Friedman (1988).Fackler (1990) also studied the role of public debt and private debt in the US usingBernanke’s (1986) contemporaneous structural VAR model. Fackler (1990) found out thatshocks in public debt have no significant effect on the interest rate, prices, or output but incontrast, shock in private credit growth significantly lowers the interest rate and inflation inthe first years. A private credit shock also significantly lowers output with a lag of aboutthree and a half years. Based on Fackler’s (1990) study, Fackler and Rogers (1993)extended the analysis in an open-economy model to include the exchange rates as anotherpotential channel of transmission mechanism. Using the US quarterly data from 1973:II to1989:I, the results of estimation again reconfirmed the presence of credit channel andsignificant effects from changes in exchange rate on credit aggregate.In recent literature development, however, new debate has emerged to identify the effects ofcredit market imperfections by analyzing the response of different forms of credit anddifferent types of borrowers to monetary policy changes. These studies have beenconducted by Kashyap, Stein and Wilcox (1993), Oliner and Rudebusch (1995), Gertler

@ Free Notes by Dr. Azali Mohamed 16and Gilchrist (1995), Oliner and Rudebusch (1996), and Bernanke, Gertler, andGilchrist (1996), amongst others.These authors rely on the fact that for a large class of borrowers, particularly householdsand small firms, close substitutes for bank credit are unavailable. They must, therefore,depend on banks for external finance. Therefore, any shock on the asset side of the bankbalance sheet has important real effects (Gertler and Gilchrist, 1995). An important policyimplication is that monetary policy works at least in part by altering the flow of bank creditor by influencing the asset side of the bank balance sheet.The proponents of broad credit aggregate further argue that in order for the credit channel tooperate, the credit measures must be imperfect substitutes for other sources of finance(Oliner and Rudebusch,1995). Thus, any narrow focus on types of debt finance may omitvaluable information such as a shift in financing patterns after a change in monetary policy.This is the main criticism of the study by Kashyap et. al. (1993), since they used commercialpaper as the only form of nonbank debt. In fact, other sources of nonbank finance such asthe issuance of longer-term debt, trade credit and loans from finance companies can also beclassified as nonbank debt. Hence, Oliner and Rudebusch (1995) proposed the used of themix of bank and nonbank debt to describe the range of nonbank financing options availableto small and large firms or what they have called the broad credit channel. Their study alsoincorporated the ‘Romer episodes’ and changes in the federal fund rates as price indicatorsof monetary policy stance. As they expected, the results showed an insignificant relationshipbetween monetary policy stance and the mix of short-term debt for both small and large

@ Free Notes by Dr. Azali Mohamed 17firms. However, when total debt stocks were estimated, the result indicated strongly thatmonetary tightening induced a significant shift in overall lending.A further study by Oliner and Rudebusch (1996) supported the existence of a broad creditchannel and its operation among small firms. This result showed that a tightening ofmonetary policy affects small firms more than large firms. Therefore, the main implicationfrom these studies is that using disaggregated forms of credit and different types ofborrowers offers new evidence on the presence of a credit channel.Studies on the United Kingdom data has been empirically tested by Matthews and Ioannidis(1992), and Dale and Halden (1993, 1995), amongst others. These studies employed theVAR method of estimation. The former used aggregated data, while the latter useddisaggregated data relating to the personal, company and real sectors. The main findinguncovered by Matthews and Ioannidis (1992) showed that both credit growth and M0played an important role in the determination of inflation and output in the UK. On the otherhand, Dale and Halden (1993) found that the importance of banks in the transmissionmechanism process and it effects varied across sectors. They also argued that sectoralmeasures of money and credit provided more accurate and timely signals of futuremovements in inflation and output.Recently, Gerlach and Smets (1995) employed the structural VAR to investigate themonetary policy transmission mechanism in the G-7 countries using data set spanning 1979:1to 1993:4. As they argued, in order to enhance the comparability of the results across

@ Free Notes by Dr. Azali Mohamed 18countries, the short-term interest rate was used as a proxy of monetary policy stance 11 .The results ashowed slight variations across countries. Their point estimates suggested thatthe output effects of a monetary policy tightening were smallest in France and Italy; andlargest in Canada, Germany and the United States; however, the effects in Japan and theUnited Kingdom fell somewhere between the two groups above.By and large, the above studies indicated that not only does money does matter to themonetary policy transmission mechanism, but both the narrow and the broad credit channelsplay a similar role. Furthermore, the survey also showed that it is very hard to find anyempirical evidence in the context of developing countries. This is not a surprise, in fact it isto be expected, because of the basic question as to whether there exists a clearimplementation of monetary policy among the developing countries. Since the ongoingdebate among the developing countries is about the credit rationing phenomenon, thefollowing subsections highlight the issue specifically.11 They estimate a three-variable SVAR - real output, prices and short-term interest rate.

@ Free Notes by Dr. Azali Mohamed 19Table 3.1: Selected Empirical Studies Relating to Developed Countriesauthor (year)Benjamin M.Friedman (1988)Ben S. Bernanke(1986)Ben S. Bernanke &Alan S. Blinder(1988)country/datafrequencythe USA;quarterly data1953:I - 1978:IVthe USA;quarterly data1953:I - 1984:IVseasonally adjustedthe USA,quarterly data1974:I - 1985:IVmodel / method of estimation variables used findings1. standard 3-variable VAR; X,P, C2. standard 4-variable VAR; X,P, M, C;both models used 8-quarterlagged, all variables used innatural logarithms,structural reduced-form VAR;six variables ; Y, P, G, M1, B, C;in the estimation all variableswere in log-level or logdifferencedformInstrumental Variables (IV);of logarithmic partialadjustment modelreal GNP,X; price deflator, P;total nonfinancial debt (credit),C; M1/M2/M3, M;real GNP, Y; the GNP pricedeflator, P; real defencespending,G; the M1 moneystock, the monetary base, B; thecredit variables, C, is the sum ofcommercial bank loans,mortgages held by S&L, andmortgages plus ‘other loans’held by mutual savings banks;the nominal interest rate, R isthe 3-month treasury bill ratereal GNP, y; GNP deflator, P;prime rate, p; 3-month treasurybill rate, r; credit aggregate isthe sum of intermediatedborrowing by households andbusiness (derived from the flowof-fundsdata)The results show that both money and creditconvey the same information about thedetermination of prices, and therefore support atwo-target monetary policy framework based onboth money and credit.Two conclusions were highlighted;First, it appears that credit shocks are importantfor output; and second, however money and creditare approximately equal important forces in themonetary transmission mechanism.The results of estimation show that the moneydemandshocks became much more importantrelative to credit-demand shocks in the 1980’s.However there is no strong evidence to reject therole of credit-demand, and thus warrant asymmetric treatment on money and credit.

@ Free Notes by Dr. Azali Mohamed 20author (year)Karl Brunner &Allan H. Meltzer(1988)Christina D. Romer& David H. Romer(1990)James S. Fackler(1990)John McCallum(1991)country/datafrequencymodel / method of estimation variables used findingsthe USA Multi-asset model not mentioned explicitly in this This study moves beyond the standard IS-LM‘summary’ article. However, framework by incorporating a credit market andtheir model can be traced in introducing a general substitution process, loan(ed.) Stein, 1976, pp. 69-103 rationing supplements interest rate rationing,relative to price changes. The results show thatthey are part of the monetary transmissionmechanism process.the USAmonthly data1941-1984the USAquarterly data1960:I - 1984:IVthe USAquarterly data1947:III - 1986:IVSt. Louis EquationOLS2SLSIVstructural VAR as suggested byBernanke (1986)all data are seasonally adjustedexcept for the interest rateCredit rationing model ofBlinder (1987)Bank lending is loans made bycommercial banks; Moneystock M1, anti-inflationaryperiods/dummies (Oct 1947,Sept 1955, Dec 1968, April1974, Aug 1978, and Oct 1979);3-month Treasury bill rate,Industrial production;real military spending; themonetary base; Corporate bondrate; M2; the GNP deflator; realGNP; the federal privatecomponents of total nonfinancialdomestic debtlog of real GNP; two types ofmonetary variables (1. residualof Barro-type quarterly moneyequation, 2. detrended growthrate of the actual money supplyM1); dummies to indicatevarious credit rationing odcredit crunch periodsBy using six ‘periods’ of restrictive monetarypolicy, they found that the forecast errors ofcredit supply is smaller than the forecast errorsof money supply. This implies that the moneychannel transmits more information than thecredit channel.real military spending is a proxy for theexogenous elements in fiscal policy. The resultsestablish the importance of credit (in total) inexplaining the relationship between credit andoutput.This study concerns the microeconomic aspect ofthe credit channel. The results of estimationshow that the credit rationing mechanism existsand accounts for about half of the totalcontribution of monetary shocks to fluctuationsin GNP.

@ Free Notes by Dr. Azali Mohamed 21author (year)Ben S. Bernanke &Alan S. Blinder(1992)country/datafrequencythe USAmonthly data1959:7 - 1989:12model / method of estimation variables used findingssix different five-variable VAR’swere testedall data were seasonally adjustedlog of CPI; log of M1 and M2;federal funds rate; 3-monthTBR; 10-year treasury bondrate; nonborrowed reserves ofdepository institutionsthree conclusions have been drawn from thisstudy. [1] the fund rate is a good indicator ofmonetary policy even for the period after 1979. [2]nominal interest rates are good forecasters ofreal variable. [3] monetary policy works in partby affecting the composition of bank assets., i.e.tight monetary policy affects the supply of bankloans.Kent Matthews andChris Ioannidis(1992)the UKquarterly data1970:I - 1990:Istructural VAR modelunadjusted datathe annual growth rates ofcredit; inflation; real income;M4 and M0the results show that [1] the existence of long-runrelationship between narrow money and inflationrate, [2] both credit growth and M0 growth playsan important role in the determination of inflationand output, [3] credit shock affects the variance ofinflation but not its mean,; the mean rate ofinflation is dominated by the rate of growth of M0,[4] M0 is a useful “advance indicator”Spencer Dale &Andrew Halden(1993)the UKmonthly data1974:6 - 1992:10VAR model(estimate disaggregated dataaccording to sector; a. personalsector, b. company sector, c. realsector)industrial production; retailsales, bank lending and depositsof both banks and buildingsocietiesThis paper focuses on the role of banks in thetransmission mechanism process. The evidencesuggests the importance of banks in this processbut varies across sectors. In addition, sectoralmeasures of money and credit provide moreaccurate and timely signals of future movementsin inflation.

@ Free Notes by Dr. Azali Mohamed 22author (year)Anil K. Kashyap,Jeremy C. Stein, &David W. Wilcox(1993)James S. Fackler &John H. Rogers(1993)Pierre Duguay(1994)country/datafrequencythe USAquarterly data1963:I - 1989:IVthe USAquarterly data1973:II - 1989:ICanadaquarterly data1970:I - 1990:IVmodel / method of estimation variables used findingsstructural modelVAR model[Bernanke (1986) model]single reduced-form equationcommercial paper; commercialbank loans; bank loans as afraction of total short-termexternal finance; the spreadbetween prime commercialpaper rates and TBR;Investment and inventory data;business cycle indicatorsfederal governmentexpenditure; GNP deflator;trade-weighted value of the USdollar; M2; total domesticnonfinancial debt; real GNP;federal funds ratereal GDP; 8-quarter MA ofquarterly changes in real shortterm interest rates (90-daycommercial paper rate minusthe fourth quarter growth ratein the GDP deflator); 12-quarterMA of the rate of growth in realcommodity prices; 8-quarterMA of the change in fiscalstance; 12-quarter of MA of therate of growth in the realexchange rate between Canadaand the USA.this study finds that tighter monetary policy leadsto a shift in firms’ mix of external financing:commercial paper issuance rises while bankloans fall. This suggests that contractionarypolicy reduce loan supply, thus affect investment,interest rates and output.This study provides two main findings[1] changes in credit are at least as important asany other variable in explaining movements inoutput, prices and interest rates[2] there is a significant effect from changes inexchange rates on credit.the result emphasizes the transmissionmechanism through interest rates and exchangerate rather than through changes in monetaryaggregates.

@ Free Notes by Dr. Azali Mohamed 23author (year)Kai J. Yang (1994)John B. Taylor(1995)Ben. S. Bernanke &Mark Gertler(1995)Stephen D. Oliner &Glenn D. Rudebusch(1995)country/datafrequencythe USAquarterly data1973:IV - 1992:IIUnited States,Germany & Japanearly 1970s to mid-1990sthe USAmonthly data1965:1 - 1993:12quarterly data of theUS ManufacturingSector,1973:IV - 1991:IImodel / method of estimation variables used findingsVAR modelfinancial market pricesframeworkVAR systemstructural model (Kashyap,Stein & Wilcox’s Model; 1993)Used three credit rationingproxies [1]. the ratio of bankloans to the sum of bank loansand commercial paperoutstanding, [2] the ratio ofbanks, commercial andindustrial loans to small firmsto similar loans to large firms,[3] the percentage of surveyrespondents indicating thatcredit has become more difficultto obtainshort-term interest rates, bondyields, exchange rateslog of real GDP; log of the GDPdeflator; log of an index ofcommodity prices and thefederal funds rate; creditaggregates;debt (bank loans, commercialpaper, other nonbank debt);monetary policy indicators (1.Dummy of ‘Romer Dates’, 2.changes in the federal fundsrateThe thesis argues that credit rationing is animportant third channel of transmissionmechanism. The results of VAR analysis supportthe hypothesis.this paper focuses on transmission mechanismthrough the financial market prices rather thanfinancial market quantities. This study offerssimilar evidence as previously discussed.The result supports the existence of the creditchannel.Their evidence is consistent with a broad view ofthe credit channel that emphasizes theinformation asymmetries faced by all lenders.

@ Free Notes by Dr. Azali Mohamed 24author (year)Mark Gertler andSimon Gilchrist(1995)country/datafrequencythe USAquarterly data1975:I - 1991:IVmodel / method of estimation variables used findingsVAR modelthe log of (etrended) real GNP;the inflation rate; the nominalFederal Funds Rate; the log offinancial variables (i.e. totalloans, business loans, totalsecurities, real estate loans,large time deposits, consumerloans - all of these variables indisaggregated form accordingto small and large firms)The authors argue that there is a strikingdifference in response of credit flows to smallversus large borrowers, potentially consistentwith the view that credit market imperfectionshelp propagate the impact of monetary policy.Stephen D. Oliner &Glenn D. Rudebusch(1996)quarterly data of theUS ManufacturingSector,1958:IV - 1992:IVInvestment equation for smalland large firms data wereseasonally adjustednet sales; cash flow; capitalstock investment spending; costof capital;Using data from the US manufacturing sector, theauthors tested for the existence of a broad creditchannel for monetary policy; which operatesthrough the total supply of loans. This studyfurther focused on the relationship betweeninternal funds and business investment.Monetary tightening affects small firms morethan large firms. In contrast, after a monetaryeasing, the relationship is little changed for allfirms. This evidence supports the existence of abroad credit channel.

@ Free Notes by Dr. Azali Mohamed 25author (year)Carl E. Walsh andJames A. Wilcox(1995)country/datafrequencythe USAmonthly data1955:01 - 1994:12model / method of estimation variables used findingsVAR modelthe log of Coincident Indicators(i.e. real personal income lesstransfer, industrial production,real manufacturing trade sales,employees on non agriculturalpayrolls); inflation; nominalfederal funds rates; primerates; and real bank loan.The results consistent with the credit view -supply of bank loans had less effect on banklending than output. Loan shock was a factor inthe boom in the late 1980s and the recession inthe early 1990s.

@ Free Notes by Dr. Azali Mohamed 273.3.2 The Microeconomic Aspect of the Credit Channel - the Credit RationingPhenomenonThe lending channel or the bank loan channel is closely related to earlier work on themicroeconomic aspect of the credit channel - the credit rationing channel. As argued byMeltzer (1995), although credit rationing is not a necessary condition for the lending view, afinding of significant credit rationing would support the lending view.Empirical evidence relating to the credit rationing channel has been extensively presented butfrom many different perspectives. In general, however, three areas of research developmenthave been identified.The first group of researchers have emphasised the difference in the nature of equilibriumand disequilibrium credit rationing (Jaffee and Modigliani (1969); Fair and Jaffee (1972);Quandt (1978); Bowden (1978); Sealey (1979); Ito and Ueda (1981); and Arndt (1982)).The second group of researchers have focused on credit rationing in the loan market withimperfect information between borrowers and lenders (Jaffee and Russell (1976); andStiglitz and Weiss (1981 and 1990)).The final group have sought to find evidence of whether or not equilibrium credit rationingplays a significant macroeconomic role (King (1986); Montiel (1991); Blinder (1987);McCallum (1991); Yang (1994); and Ma and Smith (1996)).

@ Free Notes by Dr. Azali Mohamed 28Previous studies by the first group of researchers concentrated mostly on the problemsassociated with estimating supply and demand schedules in disequilibrium markets. Amongthem, Fair and Jaffee (1972), Maddala and Nelson (1974), and Fair and Kelejian (1974),for example, argued that the maximum likelihood approach is the appropriate method ofestimation of the disequilibrium model. Their base-line models are presented in Section 3.4.In expanding these studies, Quandt (1978) and Bowden (1978) developed a framework inorder for the equilibrium hypothesis against the disequilibrium hypothesis, to be tested usingonly one model. Based on these developments in the literature, Sealey (1979) was amongthe first to estimate equilibrium vs. disequilibrium credit rationing in the commercial loanmarket using a reduced form of the loan rate function. He argued that the presence of creditrationing was simply due to the incomplete loan rate adjustment in a situation of excessdemand for loans. The results of estimation supported his hypothesis.Following Bowden (1978), Ito and Ueda (1981) estimated the loan rate adjustment speedon the U.S. and Japanese data. They found that the loan rate adjusted more slowly in Japanthan in the United States. This result confirmed the conjecture that the Japanese financialmarket, which is subject to more regulation, is further away from equilibrium than the USmarket.The second group of researchers focused attention on credit rationing in the loan marketwith imperfect information between borrowers and lenders. Two theoretical papers byJaffee and Modigliani (1969) and Stiglitz and Weiss (1981), are worth mentioning here.Both authors argued that the earlier studies of credit rationing concentrated only on the

@ Free Notes by Dr. Azali Mohamed 29supply-side of loan while neglecting the demand-side for loan and the determinants ofloan rate.In reality, banks face heterogeneous borrowers and banks are, therefore, concerned aboutthe interest rates they receive on the loan and the riskiness of the loan. Thus banks must sortpotential borrowers (the adverse selection effect) or affect the action of borrowers (theincentive effect).Stiglitz and Weiss (1981) argue “both effects derive directly from the residual imperfectinformation which is present in loan markets after banks have evaluated loan application.”Theoretically, in a situation of an excess demand for loans, deficit units are willing to paymore at the loan rate. But as banks want to maximise expected profit, such a loan is viewedas a risky loan, and thus credit is rationed. Based on this proposition, their models assumethe demand for a loan is a function of the loan rate alone, while the loan supply is a functionof the maximised expected profit, which in turn is a function of the loan rate and the loanrisk.However, these assumptions also subjected to criticism. For example, as argued by Yang(1994), this is similar to saying that the loan rate is the only decision variable and isdetermined solely by the lending bank. As a result, in reality their assumption is alsoquestionable because the loan market is competitive in nature (in the absence of governmentcontrol) and is determined by both the supply and the demand sides.

@ Free Notes by Dr. Azali Mohamed 30Recent development of literature has extended the Stiglitz and Weiss framework todetermine whether the credit rationing phenomenon is of macroeconomic importance.Hence, more recent studies by the third group of researchers have attempted to findevidence regarding the relationship between bank credit aggregate and macroeconomicvariables. See, for example, studies conducted by King (1986); Blinder (1987); McCallum(1991); Yang (1994); and Ma and Smith (1996).King (1986) constructed a simple partial equilibrium model of bank behaviour to analyse thepossibility and implications of equilibrium credit rationing. His model assumed banksoperate in three markets, namely the loan market, deposit market and securities market.The model allows the log of real loan demand to depend on the loan rate, the rate oncommercial paper, the expected inflation rate, the log of GNP, and the lagged quantity ofloans. Loan supply is assumed to depend on the loan and mortgage rates, the expectedinflation rate, a time trend, and the log demand deposits. The results of estimation show thatthe loan supply is responsive to the loan rate and thus in contradiction to the equilibriumrationing hypothesis. In addition, his findings indicate that neither commercial and industrialloans nor total bank loans significantly help output prediction in either the whole sample orany subperiod.In contrast, McCallum (1991) showed that the credit rationing mechanism did not only exist,but was also important - it accounted for about half of the total contribution of monetaryshocks to fluctuations in GNP. The estimated model was based on Blinder’s (1987)framework. Three credit rationing proxies were used. The first proxy used was the excess

@ Free Notes by Dr. Azali Mohamed 31demand for commercial loans estimated by King (1986). The second proxy used wasvarious credit crunch periods based on the work of Eckstein (1983) and Sinai (1976). Thethird proxy used was the detrended growth rate of the actual money supply (M1 and M2).Recently, Yang (1994) proposed another credit rationing proxy, i.e. the quarterly surveydata of small firms on the demand for loan. He argued that using this proxy is morerepresentative than the previous proxies because small firms are more vulnerable to creditrationing. Other proxies used were the ratio of bank loans to the sum of bank loans andcommercial paper outstanding and the ratio of banks’ commercial and industrial loans tosmall and large firms. Using the multivariate VAR, his finding supported the hypothesis thatthere was an important credit rationing channel, and in fact it had greater residualexplanatory power in predicting the output than did the money channel.3.3.3 Evidence from the Developing Countries Relating to the Credit ChannelSo far, empirical evidence regarding the credit channel in developing countries is verydifficult to find. See, Table 3.2 below. However, three most recent studies by Scholnick(1991a, 1991b), Tan (1995), and Demetriades and Luintel (1996) 12 , are worth noting.Scholnick (1991a, 1991b) and Tan (1995) 13 tested a disequilibrium model of lending ratedetermination using the Malaysian data. Both studies employed the Stiglitz and Weiss’s(1981) base-line model. Using the error-correction-mechanism specification, Scholnick’12 The study by Demetriades and Luintel (1996) actually examined the effects of various types ofbanking sector controls on the process of financial deepening. Using the Indian data, they found that,‘with the exception of a lending rate ceiling, these control are found to influence financial deepeningnegetively...Exogeneity tests suggest that financial deepening and economic growth are jointly

@ Free Notes by Dr. Azali Mohamed 32study showed that the lending rate did not fully clear the loan market. This indicated thatthe presence of the credit rationing was due to the slow adjustment of the loan rate. Similarevidence has also been portrayed by Tan (1995).Unfortunately, both of the above studies did not attempt to explain whether the creditrationing phenomenon had any macroeconomic importance relating to the Malaysianeconomy. Moreover, these studies did not investigate whether there was any relationshipbetween the monetary policy, credit and economic activity during the pre- and the postliberalisationperiods. These studies also did not test whether or not banks act in aggregateto rationing credit. Thus, whether bank credit was an important channel of transmissionmechanism in the Malaysian economy was left to be answered. To answer this question,this is one of the main tasks of this thesis which shares the current mainstream research focuson the credit view.determined. Thus, policies which affect financial deepening may also have an influence on economicgrowth.’13 Scholnick (1991a, 1991b) and Tan (1995) estimated their model using the error-correction mechanism.

@ Free Notes by Dr. Azali Mohamed 33Table 3.2: Selected Empirical Studies On Developing Countriesauthor (year)Barry Scholnick(1991a)Eu Chye Tan(1995)country/datafrequencyMalaysiamonthly data1985:1 - 1990:12Malaysiaquarterly data1979:I - 1991:IVmodel / method of estimation variables used findings‘Stiglitz- Weiss’ CreditrationingModel (1981)Lending rate adjustmentequation based on Stiglitz-Weiss’ Credit-rationing Model(1981)interbank rate; lending rate;deposit rate;total loans and advancesextended by commercial banks;average lending rate levied bycommercial banks, 3-monthTBR; UK TBR; Total deposits;excess liquidity ratio; capitaland reserves of commercialbanks as a proportion of theirassets/liabilities.This study estimates a disequilibrium model oflending rate determination in Malaysia. Theresults of estimation support the evidence ofdisequilibrium in loan market.Loan rate appears to respond only neglibly to loansupply factors, while not a single loan demandfactor appears to have influenced it. Inspite offinancial liberalization, one may conclude thatequilibrium credit rationing could prevail in theMalaysian financial system.

@ Free Notes by Dr. Azali Mohamed 353.4 Disequilibrium vs. Equilibrium Credit Rationing Models for Bank LoansThe question of credit rationing models for bank loans has been the subject of a number oftheoretical discussions during the past decades. It is generally accepted that credit rationingoccurs if the demand for loans exceeds the supply at the prevailing price.In the credit rationing literature, the credit rationing phenomenon is broadly categorised intodisequilibrium credit rationing (DCR) and equilibrium credit rationing (ECR). The DCR is ashort-run phenomenon caused by the loan rate stickiness or by institutional constraints suchas government setting the credit limits or regulations which control the limit on interest rates((Roosa (1951) and Guttentag (1960)). In a different perspective, Arndt (1982) suggestedthat the definition of disequilibrium credit rationing refers only to “government rationing”of credit. His examples of the DCR measurements include interest-rate control and directquantitative limits placed on lending institutions. For example, the imposition of interest-ratecontrols, will lead to an excess demand for credit to the extent that the loans are maintainedbelow the market-clearing level. Therefore, interest rate ceilings will lead to temporary orshort-run deviations from the equilibrium point.The equilibrium credit rationing (ECR) phenomenon is caused by the non-price factors.Again, using Arndt’s terminology, the ECR is apparently caused by “bank rationing” ofcredit. Only recently, the standard definition of ECR has been referred by Jaffee andRussell (1976) and Stiglitz and Weiss (1981) as due to either the imperfect informationbetween borrowers and lenders or to non-price factors.

@ Free Notes by Dr. Azali Mohamed 36Within the scope of this thesis, the Arndt (1982) definition of ‘disequilibrium creditrationing’ is interchangeably used for the exogenous credit rationing; and the definition of‘equilibrium credit rationing’ by Jaffee and Russell (1976) and Stiglitz and Weiss (1981)is interchangeably used for the endogenous credit rationing.The empirical evidence relating to the credit rationing channel has been discussed in Section3.3.2. In the subsequent section, the theoretical models of equilibrium vs. disequilibriumcredit rationing are presented.3.4.1 Equilibrium vs. Disequilibrium Credit Rationing ModelsFollowing a seminal paper by Fair and Jaffee (1972), many authors developed methods ofestimation for market disequilibrium vs. equilibrium. These included. among others, studiesby Fair and Kelejian (1974), Maddala and Nelson (1974), Quandt (1978), and Bowden(1978) 14 . Applications of these models to the loan market have been conducted by Sealey(1979), Ito and Ueda (1981) and King (1986).Sealey (1979) and King (1986) adopted the Maddala and Nelson model (MN), while Itoand Ueda (1981) used the Bowden model (BO). These models are described below.14 Multimarket models with disequilibrium were proposed by Ito (1980), and Gourieroux, Laffont andMonfort (1980).

@ Free Notes by Dr. Azali Mohamed 373.4.1.1 The Maddala and Nelson ModelThe Maddala and Nelson’s model consists of the following equations:= β + β + µ (3.26)D Lt rLt 1 X1t 2 1t= β + β + µ (3.27)S Lt rLt 3 X2 t 4 2tQLt= min( , ) (3.28)DtSt∆ r Lt = γ D t − S t + µt( ) ; 0 ≤ γ ≤ ∞(3.29)3where D L and S L are the demand for and supply of loans, respectively; Q L t is the observedquantity; r Lt is the loan rate; X 1t and X 2t are vectors of exogenous variables; and µ 1t , µ 2t andµ 3t are error terms.In the presence of market clearing conditions, D t = S t = Q t , equations (3.28) and (3.29) willtherefore be eliminated. On the other hand, the occurrence of any disequilibrium such ascredit rationing will lead to incomplete price adjustment. Therefore, any divergence betweenquantity demanded and supplied will be captured by equations (3.28) and (3.29).Particularly, equation (3.29) captures the price adjustment process. Thus, as suggested bySealey (1979), the above model measure the dynamic effects of rationing, i.e. the effects ofrationing during the adjustment process. Two testable hypotheses from this model include:Hypothesis 1: H o : γ = 0;[γ = 0 to indicate no price adjustment in response to excess demand and thereforeto indicate the presence of disequilibrium credit rationing].Hypothesis 2: H o : γ = ∞;

@ Free Notes by Dr. Azali Mohamed 38[γ = ∞ to indicate instantaneous price adjustment in response to market demandand supply and therefore to indicate the presence of an equilibrium market].3.4.1.2 The Bowden ModelBowden’s model consists of the following equations:= α + α +(3.30)L 'DtXt 1 2Pt u1t= β + β +(3.31)L 'StZt 1 2 Pt u 2tQLt= min( , ) (3.32){DtStP = µ P + ( 1- µ ) P }; 0 £ µ £ 1;if P > P*t 1 t -1 1 t 1 t t -1{*t 2 t -1 2 t 2 t t -1(3.33a)P = { µ P + ( 1- µ ) P }; 0 £ µ £ 1;if P > P(3.33b)where D and S are the demand for and supply of loans, respectively, which are notnecessarily observable; Q is the observed level of transactions; X’ and Z’ are vectors ofpredetermined variables; P t is the loan rate; and µ 1t , µ 2t are error terms - where µ 1 and µ 2represent the upward and downward price adjustments, respectively.To determine whether the loan rate is in equilibrium or otherwise, the null hypothesis µ 1 = µ 2=0 is tested. Acceptance of the null hypothesis suggests the presence of an equilibriummarket, otherwise, it indicates the sluggishness of price movements as shown by equations(3.33a) and (3.33b).

@ Free Notes by Dr. Azali Mohamed 39A reduced form of the loan rate equation (P t *) is derived by first equating (3.30) and(3.31) in terms of exogenous variables and the error term. Second, by substituting into(3.33), yields' 'Pt = µ Pt −1 + θ( Xt α 1− Zt β ) + θ( u t −1 1 u 2t)(3.34)where θ = ( 1− µ ) / ( β − α )2 2If the ordinary least square (OLS) result provides serially uncorrelated error terms, then theequilibrium hypothesis can be easily tested by using the t-test on the µ.According to Ito and Ueda (1981), and also claimed by Bowden (1978), the Bowdenmodel has two advantages compared to the Maddala-Nelson model. Firstly, the equilibriumhypothesis of µ= 0 can be easily tested in the Bowden model as shown by equations(3.33a) -(3.33b). Secondly, as Ito and Ueda (1981; p.694) argue “...the parameter µ isunit-free in the Bowden model, leading itself to cross-market comparisons. Thus, theBowden model specifications can capture the degree of disequilibrium across the markets.On the other hand, γ (in equation 3.29 of Maddala-Nelson’s model) is measured in units ofthe price (index) in terms of units of quantity. Thus, it is not always possible to compareestimated γ‘s for different markets.”

@ Free Notes by Dr. Azali Mohamed 403.5 The Relevance of the Credit Rationing Channel in MalaysiaDuring the pre-liberalisation period, the monetary authority implemented various measures tocontrol the loan market, namely the reserve requirements, a ceiling on the loan rate, a flooron the deposit rate and directed credit programmes with a lower lending rate. Therefore,the presence of the exogenous credit rationing channel during the pre-liberalisation periodwas straightfowardly evident.Although the domestic interest rates were liberalised after 1979, there were several eventsthat led to interest rate market distortions. For example, in 1981, the Malaysian Associationof Commercial Banks introduced the base lending rate (BLR) among its members. Then, in1987 the Central Bank took over the administration of the BLR. However, in 1991, theBLR was abolished to allow the commercial banks to determine the loan rate in a morecompetitive environment. Thus, this study hypothesises the presence of endogenous creditrationing channel in the Malaysian loan market during the post-liberalisation period.The question to be asked is why is exogenous/disequilibrium credit rationing bad for thebanking institution. As we know, the control measure sets the loan rate below the marketclearinglevel. (Consider Figure 3.2 below). In a competitive credit market environment,the banks face an upward sloping supply curve of deposit (S D ). For a given supply curve ofdeposits, plus other costs (i.e. management’s cost, interest margin), the bank’s loan supplycurve is S L . The demand curve for loans is given by L D . In equilibrium, the volume ofdeposits and loans is OL 1 . The banks pay a deposit rate of i D and charge a loan rate of i L .Thus, the bank’s margin of interest is i L -i D . In turn, consider the disequilibrium credit

@ Free Notes by Dr. Azali Mohamed 41rationing situation, i.e. when the Central Bank imposes both a ceiling on the loan rate anda floor on the deposit rate. For practical purposes the monopoly case is certainly closer tothe oligopolistic situations that describe reality in developing countries (Courakis, 1984).Imposing a floor on the deposit rate ( i D) attracts more deposits, while a ceiling on the loanrate ( i L) provides more loans to the deficit units. Because the commercial banks areheavily regulated, they have no other choice but to obey the Central Bank’s instruction.Thus, Figure 3.2 can be modified to illustrate the effect of imposing both constraints on thecommercial banks.In Figure 3.3, we add the marginal cost curve (MC) and the marginal revenue curve (MR).Thus, the Figure clearly shows that more loans can be extended in the presence of bothconstraints L , compared to the volume of loans under competition L 1 .

@ Free Notes by Dr. Azali Mohamed 42rate ofinteresti Li Di DL 1rate ofinteresti LiLiDFigure 3.2: Competitive Credit MarketL 1E 1L DLoan/DepositE 1S L S D S DLFigure 3.3: Credit Rationing MarketMRMCL DLoan/Deposit

@ Free Notes by Dr. Azali Mohamed 433.6 Statement of the Research ProblemsThe survey of the empirical literature shows a number of interesting issues relating to thecountry-coverage, the choice of data and methodology, and the evidence from previouswork. Therefore, the direction of this thesis will pay attention to the following issues.First, the evidence from developing economies has received very little attention in theliterature. Two previous studies on Malaysia did not attempt to explain whether the creditrationing phenomenon had any macroeconomic importance to the economy in question. Inaddition, both studies failed to investigate whether there is any relationship betweenmonetary policy, credit, and economic activity during the pre-liberalisation and the postliberalisationperiods. Therefore, whether money or credit, or both are an important channelof the transmission mechanism process remains to be tested.Second, the survey has shown the importance of choosing an appropriate methodology anddata set. The evidence from the industrialised countries has shown that whether usingaggregate data or disaggregated data, the results are at best mixed. Therefore, theimportant point is to pay attention to whether the data are relevant to the economic theory.Moreover, recent literature also suggests the importance of testing the time series properties.Third, most of the previous studies have employed the VAR methodology. See, Table 3.1and Table 3.2. Some researchers have used unrestricted VAR, while others have usedrestricted VAR. However, as argued by Bernanke and Blinder (1992, p. 901), “..it isextremely risky to make structural inferences from unrestricted VAR, which after all are only

@ Free Notes by Dr. Azali Mohamed 44reduced forms. If we want to measure the true structural effects of a policy change,there are only two alternatives.” First, we can specify and estimate a structural economicmodel, such as the restricted structural VAR model employed by Bernanke (1986). Thesecond alternative is to find a proper measure of monetary policy variables. Thus, thechosen variables must have a good reduced-form predictor of major macroeconomicactivities (Bernanke and Blinder, 1992, pp. 902-903). These issues are considered in thisthesis.The fourth issue is the importance of monetary policy reaction function. As argued byTaylor (1995, p. 15), “a complete story of the monetary transmission mechanism shouldthus include a description of the Central Bank’s reaction function showing how the CentralBank adjusts the [monetary policy variables] in response to various factors in the economy,including real GDP and inflation.” With the exception of Bernanke and Blinder (1992),most of the previous studies in this area have ignored this aspect. As stressed by Bernankeand Blinder (1992), if one has selected well the measure of monetary policy, then it must beable to respond to the Central Bank’s reaction of the state of the economy. In the contextof the Malaysian economy, financial liberalisation has certainly changed the enviroment inwhich monetary policy operates. Thus the effects of these factors on the domestic economyneed to be taken into account.3.7 Concluding RemarksThis chapter has provided a review of literature on the transmission mechanism process andthe channels of monetary policy. As discussed, the survey has uncovered much interesting

@ Free Notes by Dr. Azali Mohamed 45evidence relating to country-coverage, data, methodology and findings of previous work.The evidence has been used to develop the thesis’s research direction as discussed inSection 3.6.In addition, the survey also showed that efforts to investigate the channels of monetarytransmission can be divided into two categories (Cacchetti, 1995). They are:• Studies look at the relative forecasting ability of quantity aggregates relating to money andcredit. The methodology is then to ask whether measures of money or credit areinformative about future output movements.• Studies focus to the differences in the timing of the response of output to presumed policyshocks. The standard features of the methodology looking at impulse responses andvariance decompositions whether output responds differently to money or creditinnovations.Having discussed these aspects, the forthcoming chapters investigate empirically the issues,and the most immediate chapter investigates the time series properties of the data.