Economic Models - Convex Optimization

Credit and Income 203
demand since 1979 and throughout the 1980s, where, money demand
shocks became much more important relative to credit demand shocks in
the 1980s, supported by their estimation of greater variance of money.
Evidently, one of the most challenging issues of the applied monetary
theory is the existence and importance of the credit channel in the monetary
transmission mechanism. Bernanke (1988) emphasizes that according to the
proponents of the credit view, bank credit (loans) deserve special treatment
due to the qualitative difference between a borrower going to the bank for
a loan and a borrower raising funds by going to the financial markets and
issuing stock or floating bonds. 4
Kashyap and Stein (1994) leave no doubt while supporting Bernanke’s
(1983), and Bernanke’s and James’s (1991) examination of the Great
Depression in the United States, that the conventional explanation for the
depth and persistence of the Depression is one of the strongest pieces of evidence
supporting the view that shifts in loan supply can be quite important.
The supporting evidence stands strong, considering also that the decline of
intensity as seen in recessions are partially due to a cut-off in bank lending
(Kashyap et al., 1994). 5
King and Levine (1993) stress that financial indicators, such as the
importance of the banks relative to the central bank, the percentage of
credit allocated to private firms and the ratio of credit issued to private
firms to GDP, are strongly related with growth. For the relevant role of the
monetary process and the financial sector, see, in particular, (Angeloni et al.,
2003; Bernanke and Blinder, 1992; Murdock and Stiglitz, 1993; Stock and
Watson, 1989; Swanson, 1998).
More recently, Kashyap and Stein (2000) proved that the impact of
monetary policy on lending behavior is stronger for the banks with less
liquid balance sheets, where liquidity is measured by the ratio of securities
4 Stiglitz (1992) stresses the fact that the distinctive nature of the mechanisms by which
credit is allocated plays a central role in the allocation process. He identifies several crucial
reasons that banks are likely to reduce lending activity (p. 293), as the economy goes into
recession, where banks’ unwillingness and the inability to make loans obviates the effect
of monetary policy. Bernanke and Blinder (1992) find that the transmission of monetary
policy works through bank loans, as well as through bank deposits. Tight monetary policy
reduces deposits and over time banks respond to tightened money by terminating old loans
and refusing to make new ones. Reduction of bank loans for credit can depress the economy.
5 Both Bernanke and Blinder (1992) and Gertler and Gilchrist (1993) using innovations in
the federal funds rate as an indicator of monetary policy disturbances, find that M1 or M2
declines immediately, while bank loans are slower to fall, moving contemporaneously with
output.