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 American Finance & Banking Review; Vol. 2, No. 1; 2018 

                  ISSN 2576-1226  E-ISSN 2576-1234 

                       Published by Centre for Research on Islamic Banking & Finance and Business 

 

12 
 

  

Monetary Policy and Commercial Bank Lending to the Real Sector 

in Nigeria: A Time Series Study 

 
 

Ogolo1 & Tamunotonye Magnus 1  

 

 

1 Rivers State University, Port Harcourt, Nigeria 

Correspondence: Ogolo, Rivers State University, Port Harcourt, Nigeria  

 

Received: November 23, 2017     Accepted: November 29, 2017     Online Published: January 16, 2018   

 

Abstract 

This study empirically examined the effects of monetary policy on commercial banks lending to the real sector 

from 1981 – 2014. The objective was to examine the effectiveness of monetary policy in channeling bank credit to 

the real sector. Annual time series data were sourced from Central Bank of Nigeria statistical bulletin. Two 
multiple regression models were specifically estimated with the aid of Software Package for Social Sciences. The 

study modeled commercial banks credit to agricultural and manufacturing sector as the function of interest rate, 

monetary policy rate, treasury bill rate, exchange rate, broad money supply and liquidity ratio. The result shows 

collinearity that corresponds with the Eigen value condition index, and variance constant are less than the required 

value. The Durbin Watson statistics shows the absence of multiple auto correlation and negative autocorrelation, 

while the variance inflation factors indicate the absence of auto-correlation. The regression results from model one 

found that interest rate, monetary policy rate have positive relationship with commercial banks lending to the 

agricultural sector while Treasury bill rate, exchange rate, broad money supply and liquidity ratio have negative 

effect on the dependent variable. Model two found that interest rate, Treasury bill rate, exchange rate, broad money 

supply and liquidity ratio have negative effect on commercial banks lending the manufacturing sector while 

monetary policy rate have positive relationship with the dependent variable. We recommend that monetary policy 

should be harmonize with bank lending objectives to enhance commercial banks lending to the real sector of the 
economy and that management of commercial banks should formulate policies of managing the negative effect of 

monetary policy variables on its lending. 

 

Keywords: Monetary Policy, Commercial Bank Lending, Real Sector, Nigeria Economy, Time Series Study. 

 

1. Introduction 

Commercial banks are immediate financial institutions empowered law to undertake the business of lending and 

borrowing in the economy. Banking laws such as Bank and Other Financial Institutions Decree Act 1990 as 

amended (BOFIA) empowered defined the business of banking as an institution that accepts deposit and grant 

loans. This function bridges the savings-investment gap and restores equilibrium in the financial disequilibrium 

that exists among the economic agents and enhances the allocation efficiency of the economy (Ezirim, 2005). It 

also transmits the government monetary policy and facilitates the realization of macroeconomic goal of growth 

in output, full employment, price stability and external balance. 

Monetary policy is a classical instrument of fine-tuning the economy to achieve desired macroeconomic goals. 

In Nigeria, the Central Bank of Nigeria Decree 1969 empowered Central Bank the monetary policy function. 

Monetary policy is the deliberate use of monetary instruments (direct and indirect) at the disposal of monetary 



 

 

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authorities such as the Central Bank in order to achieve macroeconomic stability (Toby & Peterside, 2014). The 

application of monetary policy depends on the desired macroeconomic goals, this monetary policy can be 

expansionary or contractionary. Contractionary monetary policy aimed at moderating the anticipated inflationary 

pressures, expected to be triggered by the pre-election spending and the high liquidity injections into the banking 

system through the purchase of non-performing loans (NPLs) by the Asset Management Corporation of Nigeria 

(AMCON) while expansionary monetary policy aimed at stimulating the economy.  

Bank credit is a financial market activity where banks extend credit to deficit economic units to meet their 

financing needs (Ezirim, 2005). The monetary transmission mechanism describes how policy induced changes in 

the nominal money stock or the short-term nominal interest rates impact real variables such as aggregate output 

and employment (Ireland, 2005). Specific channels of monetary transmission operate through the effects that 

monetary policy has on interest rates, exchange rates, equity and real estate prices, bank lending and firm 

balance sheets (Toby & Peterside, 2014). The analysis of the monetary policy transmission proved how monetary 

policy changes affect the real economy, is one of the most researched areas in macroeconomic literature and a 

special focus for central bankers. Bank credit constitute the most economic important of bank functions. Bank 

credit aids in generating employment, maintain a business, take advantage of economies of scale and help to 

prevent economic disaster (Nwanyanwu, 2011). It helps in reactivating, expanding and modernizing all types of 

manufacturing enterprises through different structure of credit such as overdraft, short, long-term credit 

depending on the purpose of the loans. 

The objective of stimulating bank credit to the real sector by the monetary authority is to achieve sectoral growth. 

The real sector is recognized by the monetary policy of the economy. The importance cannot be over emphasized 

in the economic growth of the country. Its output is measure quantitatively as the contribution of the sector to 

Total Gross Domestic Product (GDP). The sector is important for variety of reasons, it produces and distributes 

tangible goods required to satisfy aggregate demand and aggregate supply in the economy (Adegbite, 2010). 

Second performance of the sector can be used to measure the effectiveness of monetary and macroeconomic 

policies (Adediran & Obasan, 2010). Third a vibrant industrial sector is capable of generating income, create 

employment absorb idle resources and increase capacity utilization which is prerequisite for economic growth 

(Mike, 2010) the manufacturing sector act as a catalyst that accelerates the pace of structural transformation and 

diversification of the economy, this enabling the country to utilize its factor endowments and to depend less on 

the foreign supply of finished goods or raw materials (Adediran and Obasam, 2010), the sector also creates 

investment capital at faster rate than other sector of the economy while promoting wider and more effective 

linkages among different sectors and facilitate the formation capital (Tobby and Thompson, 2013).     

Theoretically, two leading hypotheses have been formulated in relationship to banking sector and the growth of 

an economy. The supply leading development to economic growth, this implies that bank credit will increase the 

productive capacity of the economy while the demand leading hypothesis persist a passive to economic growth 

(Olokyo, 2011), (Ogen, 2007) (Okwo et al, 2012). Adediran and Obasam (2010) opined that a well functioning 

and efficient financial sector with sophisticated banking institutions and regulatory system will foster economic 

growth and development through efficient credit allocation to the various sectors of the economy. 

The objectives of banking sector reforms over the years has been to achieve an effective and efficient banking 

industry that will function to realize the macroeconomic goals, for instance the deregulation of the financial 

sector in 1986 was designed to reduce cost of obtaining fund (Oputu, 2010).The consolidation and realization 

reform in 2004 was motivated to reposition the Nigerian banking industry to be an active player and not a 

spectator in the global financial market (Toby, 2006). These are monetary policy operational framework; hence 

the effect of monetary policy variables on bank lending to the real sector of the economy needs to be examined 



 

 

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in relationship with the various monetary policy reforms in the past decades. 

The belief and assumption that an efficient and well structured financial system can facilitate the realization of 

monetary and macroeconomic goals dates back to the classical theories of monetary policy and Schumpeter in 

1912 which noted that services provided by the financial intermediaries are the essential driven for innovation 

and growth (Akani et al, 2016). Bank credit to the real sector is required if the monetary and the macroeconomic 

goals are to be achieved. The effects of monetary policy on the supply of bank loans depend on the 

characteristics of the banking sector. The size of banks, market concentration, capitalization and liquidity are 

among the commonly mentioned factors (Konstantins, 2008). This no doubt necessitated the various monetary 

policy reforms through the banking sector. 

However, Nigerian banks have gone through various phases of reforms through the monetary policy instruments 

and the monetary authorities. Phase 1 bordered on definition of banking business and prescription of minimum 

capital requirements, phase II regulates the banking activities with the enactment of CBN Act 1958, phase III is 

the deregulation of the banking industry, the IV phase is the re-introduction of regulations as a result of bank 

failure that affected the economy, the V phase is the democratic regime with the liberalization of the financial 

sector while the VI phase in the banking sector consolidation and recapitalization (Akani et al., 2016). The effect 

of these reforms on bank lending to the real sector remains a matter of fact and a knowledge gap. An 

examination of Central Bank of Nigerian Publication (CBN, 2015) shows that the quantity of commercial banks 

credit to the real sector of the economy continues to decrease over the periods, for instance, in 2010 percentage 

of commercial banks lending in agriculture sector is 1.67% to total sectoral credit while that of manufacturing 

sector is 12.8%, in 2013 it was 3.98% and 2.6% in 2014. The low commercial banks lending to the real sector of 

the economy contributed to the low performance of the economy at large.  

The effect of monetary policy on commercial banks performance has long been a research interest and 

documented in literature. The relationship between monetary policy and bank lending to the real sector of the 

economy is lacking in literature. Similar studies such as Ajayi and Atanda (2012), Ubi et al., (2012) examined 

the relationship between monetary policy and commercial banks lending behaviour, the study of (Konstantins, 

2008), (Shuzhang et al., 2010) examined commercial banks and the transmission channel of monetary policy in 

Turkey. This study therefore intends to examine the effect of monetary policy on commercial banks to the real 

sector in Nigeria.     

2. Literature Review 

2.1Monetary Policy in Nigeria 

A monetary policy shift tends, generally, to transmit a change for the future in the expected behavior of 

macroeconomic variables (Toby & Peterside, 2014). The Central Bank of Nigeria (CBN) is mandated by the 

CBN act of 1958 to promote and maintain monetary stability and a sound financial system in Nigeria. Just like 

other central banks, the CBN has the ―end‖ of achieving price stability and sustainable economic growth through 

the ―means‖ of monetary policy. Embedded in this twin objectives are (1) the attainment of full employment, (2) 

maintaining stability in the long-term interest rates and (3) pursuing optimal exchange rate targets. To achieve 

these multiplex objectives, the CBN operates through a system of targets. These are; the operational targets, the 

intermediate targets and the ultimate target (Ibeabuchi, 2007).  The Central Bank uses its operational target over 

which it has deterministic control to influence the intermediate target (broad money) which eventually affects the 

ultimate targets (inflation and output). In setting its targets, the CBN considers an information set that is feed into 

by contemporaneous and lagged values of real Gross Domestic Product (GDP), real investment prices, real 

wages, labour productivity, fiscal operations and balance of payments performance, among others. Depending on 

the relative importance attached to the various information elements, the CBN sets its target parameters for its 



 

 

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quantity-based nominal anchor and its price-based anchors. The bank generally implements its monetary policy 

programmes using the market-based and rule-based techniques.  

When implementing monetary policy using the rule-based technique, the CBN uses direct instruments like 

selective credit controls, direct regulation of interest rates and moral suasion. While indirect instruments like the 

Open Market Operation (OMO), discount rate and the reserve requirements are used when implementing 

monetary policy programmes using the market-based approach. Since its inception, the CBN has implemented 

monetary policy using various combinations of these two techniques with more or less emphasis on the one. 

Depending on the emphasis that is placed on either of the techniques, the evolution of monetary policy in Nigeria 

can be classified into two phases: (1) the era of direct controls (1959- 1986) and (2) the era of market-based 

controls (1986-date). The era of direct controls was a remarkable period in monetary policy management in 

Nigeria, because it coincided with several structural changes in the economy; including the shift in the economic 

base from agriculture to petroleum, the execution of the civil war, the oil boom and crash of the 1970s and early 

1980s respectively and the introduction of the Structural Adjustment Programme (SAP).  

During this period CBNs monetary policies focused on fixing and controlling interest rates and exchange rates, 

selective sectoral credit allocation, manipulation of the discount rate and involving in moral suasion. Reviewing 

this period, Omotor (2007) observe that monetary policy was ineffective particularly because the CBN lacked 

instrument autonomy and goal determination, being heavily influenced by the political considerations conveyed 

through the Ministry of Finance. 

Progressively, the implementation of the SAP programme which commenced in 1986 ushered in a new era of 

monetary policy implementation with market-friendly techniques in Nigeria. The capacity of the CBN to carry 

out monetary policy using market friendly techniques was letter reinforced by the amendments made to the CBN 

Act in 1991 which specifically granted the CBN full instrument and goal autonomy. Using this technique, the 

CBN indirectly influences economic parameters through its Open Market Operations (OMO). These operations 

are conducted wholly on Nigerian Treasury Bills (TBs) and Repurchase Agreements (REPOs), and are being 

complimented with the use of reserve requirements, the Cash Reserve Ratio (CRR) and the Liquidity Ratio (LR). 

These set of instruments are used to influence the quantity-based nominal anchor (monetary aggregates) used for 

monetary programming. On the other hand, the Minimum Rediscount Rate (MRR) is being used as the 

price-based nominal anchor to influence the direction of the cost of funds in the economy. Changes in this rate 

give indication about the monetary disposition of the Bank, whether it is pursuing a concessionary or 

expansionary monetary policy. This rate has generally been kept within the range of 26 and 8 percent since 1986. 

As a companion to the use of the MRR, the CBN latter introduced the Monetary Policy Rate (MPR) in 2006 

which establishes an interest rate corridor of plus or minus two percentage points of the prevailing MPR. Since 

2007, this rate has been held within the band of 10.25 and 6 percent.  

2.2 Monetary Policy and Credit Channel 

Monetary policy models describe an economy in which there is an excess supply; hence, aggregate output is 

demand-determined in the short to medium run. The agents in this macro model include the (a) households, (b) 

domestic firms, (c) the government; (d) the rest of the world provides capital, goods and services demanded by 

the domestic economy and a market for domestic production and (e) the central bank. In the model, the central 

bank has the task of anchoring the nominal side of the economy. The central bank adopts an inflation targeting 

framework (IT) and is a flexible inflation targeted and sets a short-term interest rate to achieve an inflation target, 

and, consequently provides nominal stability. There are lags and delays between a change in interest rate and 

inflation. Given these lags and price and wage rigidities, the use of a simple interest rate rule is required to 

anchor inflation in the long run. Meanwhile, asset markets are imperfect. The nominal exchange rate is allowed 



 

 

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to transitorily deviate from purchasing power parity (PPP) so that movements occur in the real exchange rate. In 

addition, the nominal short-term interest rates play the leading role as the instrument of monetary policy. The 

transmission mechanism starts with the domestic interest rate policy. The overnight reverse repurchase rate (RRP) 

is prescribed as the nominal interest rate which follows a behavioral equation required to anchor inflation in the 

long run (Clarida, Gali and Gertler, 2000). The overnight RRP adjusts to inflationary pressure measured by the 

difference between the inflation forecast and the inflation target announced by the Government and the output 

gap. This is seen as, 

,)()(   

ttt

p

t qqr
          (1) 

Where rp‘ is the RRP,  connotes the neutral monetary policy stance, f is the one-quarter ahead inflation 

forecast, * is the medium-term inflation target announced by the Government, q is real output, q* is potential real 

output, and an error term, 

The RRP rate is transmitted to the benchmark interest rate rd through the natural arbitrage condition. In the 

model, the benchmark interest rate is the 91-day Treasury bill rate. As seen in equation 2, rd is also affected by 

other variables, such as the overnight RRP rp, inflation expectations e, foreign interest rate ru, real money 

supply m and an error term. 

.  t

u

t

e

t

p

t

d

t mrrr
        (2) 

Treasury bill rate is higher, the higher the overnight RRP rate, the higher the inflation expectations, the higher the 

foreign interest rate, and the lower the level of money supply. In this equation, there is a direct channel from the 

BSP‘s policy rate to the 91-day Treasury bill rate.  

Changes in the 91-day Treasury bill rate rd are then carried over to the changes in the other market interest rates, 

such as lending rates is the natural arbitrage condition. 

.  d

t

l

t rr
                      (3) 

It is also assumed that the short-run domestic inflation is relatively sticky, indicating that inflation expectations 

for the short term are similarly sticky. This further implies that by controlling the nominal overnight RRP rate, 

the BSP can also affect the short-term real RRP rate or the difference between the short-term REP rate and 

short-term inflation expectations. The overnight RRP is expected to lower short and longer real interest rates, and 

consequently affect economic activity. 

Changes in the overnight RRP rate also affect bank credits as seen in equation 4 below 

,)(   nkmrqc tt

e

t

l

tt

p

t        (4) 

where Cp is private credit, q is real output, r1 is bank lending rate,  is inflation expectations, m is money supply, 

k is the bank regulatory capital to risk-weighted assets (in excess of the required BSP capital to asset ratio), fl is 

banks‘ non-performing loan ratio and an error term. 

Meanwhile, k is expected to have a positive coefficient as higher capital buffer (relative to the regulatory capital) 

to absorb losses helps banks to expand credit. In Bayoumi and Melander (2008), the balance sheets of firms and 

households are included. In the absence of a longer and consistent series for the Philippines, the model  is 

limited to the consolidated balance sheets of commercial/universal banks, thrift and rural banks. In the case of n, 

a negative coefficient is expected, as higher shares of non-performing loans to total loans are riskier, hence, 



 

 

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banks are expected to be prudent in extending new loans. Meanwhile, the presence of q in model 4 reflects the 

feedback look from income to bank credit via the financial accelerator effect. 

Bank credit together with net other items determine the level of money supply from the asset side. It should be 

noted that in the model, money supply is an indicator of the quantity of money that the economy requires, 

without the BSP setting any target for it. From the liability side, the impact of changes in the real market interest 

rates 
)( e

t

d

tr 
affects currency in circulation in the monetary system as in equation 5: 

.)(   e

t

d

tt

c

t rqc
          (5) 

Equation 5 is then added to deposit liabilities to arrive at the total money supply level (m) from the liabilities 

side and feeds back into model 4. To determine the impact of bank credit on spending, real personal consumption 

C and real investment spending I are re-specified. Real consumption C in model 6 follows the permanent income 

and life-cycle hypothesis. In the long run, it is assumed to depend on real disposable income di and real wealth m. 

The presence of di implies that a proportion of households are ―liquidity constrained‖ while Cp implies that 

households are ―credit constrained‖ in the short-run (Bayoumi and Melander, 2008; Greenlaw et al., 2008). The 

remaining households‘ consumption, however, is determined by their wealth positions. In this model, real wealth 

m includes real financial aspects (including the market value of domestic equity). 

.)(   e

t

d

t

p

tttt rcmdic
       (6) 

Meanwhile, the inclusion of the long-term real interest rate

e

t

d

tr 
 in equation 6 captures the direct 

substitution effect between consumption and savings. In addition, the presence of accounts for the time lag 

before consumption responds to changes in the real interest rate.The desired investment spending by domestic 

firms It in equation 7 uses the accelerator principle linking the desired fixed capital with output qt, real lending 

rate 

e

t

l

tr 
and the exchange rate e (Montiel 2003) 

.  t

u

t

e

t

p

tI mrr
T                          (7)                          

The impact of bank credit is seen as directly affecting investment in equation 7. In this model, technology is 

fixed. Moreover, firms hold inventories which represent insurance against demand surprises. However, this is 

taken as exogenous in the model, implying that firms make their decisions regarding capital, labor and prices 

first, and then make decisions about the desired level of inventories. The choice of investment demand model 

stems from the ease of identifying the policy instruments (in this model interest rate and exchange rates) 

available to monetary authorities to influence the aggregate supply resulting from investment behavior. However, 

in the empirical estimation, an attempt is made to produce a complete and detailed estimation of investment in 

terms of capital stock and employment. This is essential in determining the link between investment and 

production capacity and consequently the output gap 

In sum, changes in interest rates and bank credits lead to changes in the real sector through consumption and 

investment. All the changes in spending behavior, when added up across the whole economy, generate changes in 

aggregate spending. Total domestic expenditure plus the balance of trade in goods and services reflects the 

aggregate demand in the economy, and is equal to gross domestic product (GDP). GDP (demand) feeds into the 

GDP (production) side which consists of two sectors: the primary sector (agriculture) and the advanced sector 



 

 

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(industry and services). The output of the agriculture sector is exogenous in the model. This leaves us with the 

industry and services sectors which are assumed to have excess capacity. Hence, supply responds to the level of 

aggregate demand. GDP feeds into banks‘ capital to asset ratio k in equation 8 below. 

.  tK q
t                             (8)                                                             

From Bayoumi and Melander (2008), bank lending standards determine changes in banks‘ capital to asset ratio. 

A limitation of equation 8 is the absence of bank lending standards. In Bayoumi and Melander (2008), bank 

lending standards are based on answers from the quarterly Federal Reserve Bank‘s survey of bank loan officers.  

In the initial specification, there was an attempt to include the overnight RRP rate (equation 1) in equation 8 to 

examine the impact of monetary policy actions on changes in bank capital. However, in the empirical estimation, 

the overnight RRP rate was dropped as it yielded insignificant coefficient.  Moving forward, there are two 

distinct and mutually reinforcing feedback channels in Bayoumi and Melander (2008) framework. The first 

channel is that as spending and income fall, loan losses increase and thus there are further negative effects on 

bank capital. The second feedback channel is that a deterioration of incomes (and balance sheets for households 

and firms) has a further negative financial-accelerator effect on credit and spending. This model allows for these 

two feedback channels through equations 4 and 8. 


 ttY qqg

t                        (9)                                                                                                        

Potential output and the resulting gap as measure of future inflationary pressures have regained importance under 

the IT framework. As indicated in equation 9, output gap in this model is estimated based on Dakila (2001) in 

which it is expressed as the difference between the log of a one quarter moving average of supply side (industry 

and services) GDP (depersonalized series) q and potential output 
q

. 

.  tt

M

t

g

tP WmpYw

t                 (10)                                                                   

The output gap Yg then feeds into the wholesale price index PW in equation 10. The whole price index in this 

model is affected by the average prices of merchandise imports in pesos PM the excess liquidity as indicated by 

real money supply m relative to gross domestic product and the average compensation (or wages) for industry 

and services sectors W. This specification makes the pricing decision based on a flexible mark up. Changes in 

the wholesale price drives prices of the industry and services sectors, and finally the final demand prices, final 

demand prices are dependent on the relative weights of industry and services sector prices and are contained in 

the implicit GDP deflator. This then is the basis of headline inflation.  Because of the forward-looking nature of 

inflation targeting, the role of inflation expectations in this transmission mechanism becomes crucial. Indicators 

of inflation expectations include the two-year ahead inflation forecast. 

.1

  ttt

e

t V
                     (11)                                                                                

The estimation of long-run inflation expectations 

e

t in equation 11 follows a hybrid structure that contains both 

forward-looking and backward-looking expectations. The structure includes rational component of inflation, 

indicated by the medium-term (three to five years) inflation target announced by the Government 



t
, and 



 

 

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contemporaneous and inertial components indicated by current t , and past inflation rate 1t The rational 

component is based on Demertzis‘ and Viegi‘s (2005) work on inflation targets as focal points for long run 

inflation expectations. The idea is that in the absence of concrete information of inflation expectations, the only 

information that agents have is the quantitative inflation target announced by the Government. 

2.3 The Monetarist and Transmission of Monetary Policy  

 The traditional textbook (Keynesian) channel is known as the interest rate or the intertemporal 

substitution channel: 

 yYCiM d)1()(
         (12) 

 Expanding ‗money‘ (M) reduces interest rates (i), reduces the cost of borrowing for firms (and 

consumers), leads to increased consumption (C) as well as investment (I) and therefore higher demand 

(Y
d
), a bigger output gap (y) and finally higher prices and inflation (π) 

The monetary transmission mechanism 

2.4 The Interest Rate Channel and Policy Responses 

 But Bernanke and Gertler (1989) pointed out that the macroeconomic response to policy-induced 

interest rate changes was considerably larger than implied by conventional estimates of interest 

elasticity‘s of consumption and investment 

• This suggests that mechanisms other than the interest rate channel may also be at work in the transmission of 

monetary policy 

2.5 The Exchange Rate Channel: Net Exports 

 The exchange-rate channel 

 yNXei
           (13) 

 Lower interest rates (i) lead to a depreciation of the exchange rate (e), an increase in competitiveness, 

an improved trade balance (due to higher net exports, NX) and increased demand, a larger output gap 

and finally higher inflation 

 Moreover. The monetary transmission mechanism 

2.6 The Exchange Rate Channel: Import Prices 

 The exchange-rate channel: 

 mPei
             (14) 

 An exchange rate (e) depreciation also raises import prices (Pm), which are important determinants of 

firms‘ costs and the retail price of many goods and services: this directly affects the price level and 

(temporarily) inflation 

 An appreciation should reduce inflation (with a longer lag if prices are sticky on the downside). The 

monetary transmission mechanism. 

 



 

 

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2.7 The Exchange Rate Channel: Net Wealth 

 The exchange-rate channel: 

  yNWei
           (15) 

 An exchange rate depreciation increases the relative value of foreign-denominated assets and liabilities 

and therefore net wealth (NW), affecting demand 

 The sign of the effect depends on the make-up of balance sheets  

The monetary transmission mechanism 

2.8 Other Asset Price Effects: Investment (Tobin’s Q) 

 The investment channel (Tobin‘s q): 

 yqePi 1
 

 Consider two ways of increasing the size of a firm: 

 buy another firm (and acquire ‗old‘ capital); or 

 invest in new capital 

 The ratio of the market value of a firm to the replacement cost of its assets is known as Tobin‘s q 

 Tobin (1969) argued that a firm should invest in new buildings and equipment if the stock market will 

value the project at more than its cost (that is, if the project‘s q is greater than 1) 

 Increased equity prices (Pe) mean that new investment projects have become relatively cheaper to 

finance and therefore more attractive. The monetary transmission mechanism. 

2.9 Other Asset Price Effects: Consumption 

Other asset price effects: consumption  

 yCTWPei
         (16) 

 The permanent income hypothesis postulates that consumers‘ spending is related to (total) wealth 

 Increased wealth (as a result of higher equity prices, Pe, say) if it is perceived to be permanent leads to a 

(much smaller) increase in (desired) consumption. The monetary transmission mechanism. 

2.10 Other Asset Price Effects: Housing Wealth 

 Other asset price effects: housing wealth 

 yCTWPi h ?
         (17) 

 Increased house prices (rh) are often associated with increased private consumption in the UK/US 

 Housing wealth represents greater wealth for some (but for the economy as a whole?); 

 Housing wealth increases available collateral and therefore reduces credit constraints; and 

 People may be more likely to change house or spend on improvements/consumer durables (in a process 



 

 

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called mortgage equity withdrawal) The monetary transmission mechanism 

2.11 Bank Lending Channel of Monetary Policy Transmission 

The monetary policy transmission mechanism refers to the routes through which monetary impulses are 

communicated to the real sector of the economy. Mishkin, (1995), argued that to be successful in conducting 

monetary policy, the monetary authorities must have an accurate assessment of the timing and effect of their 

policies on the economy, thus requiring an understanding of the mechanism through which monetary policy 

affects the economy. The bank lending channel represents the credit view of this mechanism. According to this 

view, monetary policy works by affecting bank assets (loans) as well as banks‘ liabilities (deposits). The key 

point is that monetary policy besides shifting the supply of deposits also shifts the supply of bank loans. For 

instance, an expansionary monetary policy that increases bank reserves and bank deposits increase the quantity 

of bank loans available. Where many borrowers are dependent on bank loans to finance their activities, this 

increase in bank loans will cause a rise in investment (and also consumer) spending, leading ultimately to an 

increase in aggregate output, (Y). The schematic presentation of the resulting monetary policy effects is given by 

the following:  

M ↑ → Bank deposits ↑ → Bank loans ↑ →I ↑ → Y ↑        (18) 

(Note: M= indicates an expansionary monetary policy leading to an increase in bank deposits and bank loans, 

thereby raising the level of aggregate investment spending, I, and aggregate demand and output, Y, ). In this 

context, the crucial response of banks to monetary policy is their lending response and not their role as deposit 

creators. The two key conditions necessary 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 importance of the credit channel depends on the extent to which 

banks rely on deposit financing and adjust their loan supply schedules following changes in bank reserves; and 

also the relative importance of bank loans to borrowers. Consequently, monetary policy will have a greater effect 

on expenditure by smaller firms that are more dependent on bank loans, than on large firms that can access the 

credit market directly through stock and bond markets (and not necessarily through the banks). 

2.12 Monetary Transmission Mechanism, Credit Frictions and Macro prudential Regulation  

The monetary transmission mechanism describes how policy induced changes in the nominal money stock or the 

short-term nominal interest rates impact real variables such as aggregate output and employment (Ireland, 2005). 

Specific channels of monetary transmission operate through the effects that monetary policy has on interest rates, 

exchange rates, equity and real estate prices, bank lending, and firm balance sheets. Recent research shows how 

these channels work in the context of dynamic, stochastic general equilibrium models. Bernanke and Gertler 

(1995) classify three channels of monetary policy as the balance sheet channel, the bank-lending channel and the 

credit channel. The balance sheet channel focuses on monetary policy effects on the liability side of the 

borrowers‘ balance sheet and income statement, including variables such as borrowers‘ networth, cash flow and 

liquid assets whilst the bank lending channel centres on the possible effect of monetary policy actions on the 

supply of loans by depository institutions.  

However, most of the previous empirical literature on the effects of credit aims to distinguish between different 

transmission mechanisms, such as the balance sheet channel, the bank lending channel and the bank capital 

channel (see Oliner and Rudebusch, 1996; van den Heuve, 2002). Since these different channels have similar 

predictions for aggregate quantities, many empirical studies use micro-level data from banks and/or firms rather 

than the aggregate data (Bayoumi and Melander, 2009). One consequence of these empirical studies is that the 



 

 

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general conditions of the banking sector and the specific characteristics of individual banks can have predictable 

impacts on the monetary transmission mechanism. In fact, recent studies have emphasised a risk-taking channel 

of monetary policy that places more emphasis on the willingness of banks to expand their balance sheet (Borio 

and Zhu, 2012; Adrian and Shin, 2011). The works of Adrian and Shin (2011) provide an overview of how 

changes in risk appetite, which is partly a function of monetary policy, generates a critical link between monetary 

policy changes, the actions of financial intermediaries, and the impact on the real economy.  

Boivin et al (2010) have argued that the monetary transmission mechanism is one of the most studied areas of 

monetary economics for two reasons. First, understanding how monetary policy affects the economy is essential 

to evaluating what the stance of monetary policy is at a particular point in time. Second, in order to decide on 

how to set policy instruments, monetary policy makers must have an accurate assessment of the timing and 

effects of their policies on the economy.  

Over the last two decades, beginning with the pioneering works of Bernanke and Gertler (1989), economists 

began to introduce credit frictions into models that allowed for borrowing and lending in equilibrium. A number 

of studies have shown that these credit frictions could amplify the macroeconomic fluctuations introduced by 

certain shocks, hence the credit frictions are often referred to as the ―financial accelerator‖ (Kiyotaki and Moore, 

1997, Carlstrom and Fuersto, 1997 and Bernanke, et al, 1999). The recent papers have contributed to this 

literature by adding a relatively simple realistic, and well-defined financial intermediation sector into a 

large-scale dynamic stochastic general equilibrium (DSGE) model (Gertler and Kiyotaki, 2009; Curdia and 

Woodford, 2010). These works analyze the relationship between the financial intermediation sector and 

macroeconomic volatility by examining both the indirect effect of the sector on the propagation of non-financial 

shocks and the direct effects of financial shocks that inhibit financial intermediation.  

Tayler and Zilberman (2014) examine the macro prudential roles of bank capital regulation and monetary policy 

in a Dynamic Stochastic General Equilibrium (DSGE) model with endogenous financial frictions and a 

borrowing cost channel. The model identifies various transmission channels through which credit risk, 

commercial bank losses; monetary policy and bank capital requirements affect the real economy. These 

mechanisms generate significant financial accelerator effects, thus providing a rationale for a macro prudential 

toolkit. Following credit shocks, counter cyclical bank capital regulation is more effective than monetary policy 

in promoting financial, price and overall macroeconomic stability. For supply shocks, macro prudential 

regulation combined with a strong response to inflation in the central bank policy rule yield the lowest welfare 

losses. The findings emphasize the importance of the Basel III regulatory accords and cast doubts on the 

desirability of conventional Taylor rules during periods of financial stress.  

2.13 Banks and the Transmission of Monetary Policy 

The traditional interest rate, or money, view of the transmission of monetary policy focuses on the liability side 

of bank balance sheets. The important role played by banks in this transmission mechanism arises from the 

reserve requirement constraint faced by banks. Because banks rarely hold significant excess reserves, the reserve 

requirement constraint is typically considered to be binding at all times. Thus, shifts in monetary policy that 

change the quantity of outside money result in changes in the quantity of inside money in the form of the 

reservable deposits that can be created by the banking system. 

The transmission mechanism functions as follows. When the monetary authority undertakes open-market 

operations in order to tighten monetary policy (by selling securities), the banking industry experiences a decline 

in reserves. The fractional reserve system then forces banks (as a whole) to reduce reservable deposits in order to 

continue to meet the reserve requirement. This shock, which is exogenous to the banking sector, thus constrains 



 

 

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bank behavior. To induce households to hold smaller amounts of reservable deposits (transactions accounts), 

interest rates on other deposits and non-deposit alternatives must rise. That is, since the supply of transactions 

deposits has declined relative to the supply of alternative assets, interest rates on these alternative assets would 

have to rise to clear the market for transactions deposits.  

While that accurately describes non-crisis times, two recent notable exceptions are the episodes of quantitative 

easing policies undertaken by the Bank of Japan in response to the crises experienced by Japan in the 1990s and, 

in response to the most recent financial crisis, also by the Federal Reserve, the Bank of England, and the 

European Central Bank.  rate is transmitted to longer term interest rates, aggregate demand declines. However, 

an important characteristic of the recent financial crisis has been the substantial expansion of excess reserves in 

the U.S. banking system. Consequently, with the reserve requirement failing to serve as a binding constraint on 

most institutions, an increasing focus has been placed on the important role of alternative transmission 

mechanisms. 

2.14 The Broad Credit Channel 

The broad credit channel, also referred to as the balance sheet effect or financial accelerator, does not require that 

a distinction be drawn among the alternative sources of credit. Instead, it is predicated on credit market 

imperfections associated with asymmetric information and moral hazard problems. Research on the credit 

channel was motivated, in large part, by the puzzle that monetary policy shocks that had had relatively small 

effects on long-term real interest rates appeared to have had substantial effects on aggregate demand. This 

literature attributes the magnification, or propagation, of monetary policy shocks to frictions in the credit markets 

Because of the information asymmetries between borrowers and lenders, external finance is an imperfect 

substitute for a firm's internal funds. 

The broad credit channel posits that an increase in interest rates associated with a tightening of monetary policy 

causes deterioration in firm health, in terms of both net income and net worth. A firm's net income is impaired 

both because its interest costs rise and because its revenues deteriorate as the tighter monetary policy slows the 

economy. A firm's net worth is adversely impacted as the lower cash flows emanating from the firm's assets are 

discounted using the higher interest rates associated with the tightening of monetary policy. The deterioration in 

the firm's net income and the reduction in the collateral value of the firm's assets, in turn, cause an increase in the 

external finance premium that must be paid by the firm for all sources of external finance. This increase in the 

cost of external funds for borrowers over and above the risk-free interest rate then results in a reduction in 

aggregate demand in addition to that due to the increase in the risk-free interest rate associated with the interest 

rate channel of the transmission of monetary policy. 

2.15 The Bank Lending Channel 

With the bank lending, or credit, view, in contrast to the money view, the focus of the transmission mechanism 

operating through bank balance sheets shifts from bank liabilities to bank assets. When monetary policy tightens, 

the reduction in available bank reserves forces banks to create fewer reservable deposits, banks must then either 

replace the lost reservable deposits with non-reservable liabilities, or shrink their assets, such as loans and 

securities, in order to keep total assets in line with the reduced volume of liabilities. Typically, one would expect 

to observe some combination of these responses, although Romer and Romer (1990) question the extent to which 

banks, in an age of managed liabilities, are unable to easily replace reservable deposits.  

However, to the extent that banks are unable or unwilling to fully insulate their loan portfolio, the interest rate 

effect on aggregate demand is supplemented with an additional effect stemming from a reduction in the 



 

 

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availability of bank loans that further slows aggregate demand. In a simple world with three assets money, 

government bonds, and bank loans—three conditions must be satisfied for the bank lending channel to be 

operational in the transmission of monetary policy (see, for example, Bernanke and Blinder 1988; and Kashyap 

and Stein 1994). First, as with the interest rate view, prices must not adjust fully and instantaneously to a change 

in the money supply. That is, money is not neutral, at least in the short run. Second, open-market operations must 

affect the supply of bank loans. Third, loans and bonds must not be perfect substitutes as a source of credit for at 

least some borrowers. Of course, the set of assets can be expanded to include private sector bonds and nonbank 

intermediated loans, in which case the narrower bank lending channel is distinguished from the broad credit 

channel by requiring that private sector bonds and nonbank intermediated loans not be perfect substitutes for 

bank loans as a source of credit for at least some borrowers. Because only the second and third conditions 

distinguish the bank lending view from the money view, and because substantial evidence exists that wages and 

prices are not perfectly flexible, it will be assumed for the purposes of this discussion that the first condition 

holds. 

2.16 Bank Lending and the Transmission of Monetary Policy 

Empirical researchers investigating the bank lending view face several challenges. First, they need to determine 

whether a change in monetary policy does affect bank lending. Then, if bank lending is affected, the issue 

becomes the extent to which shifts in bank loan supply do, in fact, affect aggregate demand. The difficulties in 

establishing the first point are twofold. First, to what extent are banks able to insulate their loan portfolios from 

monetary policy shocks by adjusting other components of their balance sheet? The second difficulty concerns 

identifying a bank-loan supply shock, insofar as a decline in bank loans following a tightening of monetary 

policy may simply reflect a decline in loan demand rather than a decline in the supply of loans. 

2.17 Monetary Policy and Bank Loan Supply 

While the theoretical conditions required for bank loan supply to be affected by changes in monetary policy are 

clear, it is not straightforward empirically to disentangle shifts in loan supply from shifts in loan demand. At an 

aggregate level, Bernanke and Blinder (1992), among others, show that bank lending does contract when 

monetary policy becomes tighter. However, such an observed correlation may reflect a reduction in loan demand 

as the economy weakens in response to the tighter monetary policy, rather than reflecting a reduction in bank 

loan supply.  

Furthermore, even if one observed an initial increase in bank loans or a notable delay in the decline in bank loans 

following a tightening of monetary policy, such evidence would not necessarily conflict with an inward shift in 

bank loan supply in response to a tightening of monetary policy. For example, the initial response of firms to a 

tightening of monetary policy may be an increase in loan demand resulting from the need to finance the buildup 

of inventories, as aggregate demand initially declines faster than production. Even though banks may decrease 

loan supply immediately to borrowers without loan commitments, the total amount of bank loans may 

temporarily increase, as banks are forced to honor existing loan commitments (Morgan 1998). Thus, the 

endogeneity issues associated with using aggregate data for total loans make it impossible to obtain a clear 

answer. 

Kashyap, Stein, and Wilcox (1993) provide an alternative approach for identifying an effect of monetary policy 

on bank loan supply, although the analysis is still based on aggregated data. They investigate the change in the 

mix of bank loans and commercial paper in the composition of firms‘ external finance, with the argument being 

that if the decline in loans is due to a general decline in credit demand associated with a slowing of the real 

economy, then demand for other types of credit should decline similarly. Finding that a tightening of monetary 



 

 

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policy is associated with an increase in commercial paper issuance and a decline in bank loans, they conclude 

that a tightening of monetary policy does reduce bank loan supply rather than the decline in bank loans simply 

reflecting a reduction in credit demand as the economy slows. In the same vein, Ludvigson (1998) investigates 

the composition of automobile finance between bank and nonbank providers of credit. She finds that, in fact, a 

tightening of monetary policy reduces the relative supply of bank loans, consistent with the bank lending channel. 

In contrast, Oliner and Rudebusch (1996b) revisit the Kashyap, Stein, and Wilcox (1993) approach using a 

different measure of the mix of external finance and disaggregating the data into two separate components, one 

for small firms and one for large firms. They argue that their evidence is consistent with the broad credit channel 

rather than with the more narrowly defined bank lending channel. However, this only highlights the weaknesses 

associated with attempting to isolate bank loan supply shocks from shifts in credit demand using aggregate data. 

In fact, in their reply, Kashyap, Stein, and Wilcox (1996) close by suggesting that a more definitive answer will 

have to rely on an analysis using micro data at the individual bank and firm levels. By advancing the analysis to 

focus on panel data, the literature has been able to obtain more definitive results about the impact of changes in 

monetary policy on bank loan supply. The key has turned out to be relating cross-sectional differences in bank, 

or banking organization, characteristics to differences in the extent to which banks were able to insulate their 

loan portfolios from a tightening of monetary policy. Two aspects of bank characteristics appear to have been the 

primary focus. First, the ability of banks to raise nonreservable liabilities to replace the lost reservable deposits is 

a key factor in determining the extent to which a bank must adjust its loan portfolio when monetary policy is 

tightened. Because these funds are, for the most part, uninsured liabilities, bank characteristics related to banks‘ 

access to external funds—for example, size, health, and direct access to capital markets—play an important role 

in determining the ability of banks to insulate their loan portfolios from the effects of changes in monetary policy. 

Second, because banks face a capital requirement constraint in addition to the reserve requirement constraint on 

their activities, banks may differ in their response to a change in the stance of monetary policy, depending on 

which constraint is more binding. If the capital ratio requirement is the binding constraint, easing the reserve 

requirement constraint through open market operations should have little, if any, effect on bank lending. That is, 

because the binding constraint has not been eased, expansionary monetary policy, at least if operating through 

the bank lending channel, would be like ‗pushing on a string.‘ 

Kashyap and Stein (1995) note that with a tightening of monetary policy and the associated loss in reservable 

deposits, it is costly for banks to raise uninsured deposits, however, banks differ in the degree to which they have 

access to external funds. Kashyap and Stein hypothesize that bank size is a reasonable proxy for the degree of 

access to uninsured liabilities, with smaller banks having more limited access, and thus having their loan 

portfolio impacted more by a tightening of monetary policy. Indeed, they find empirical support for the 

proposition that small banks are more responsive (shrink their loan portfolios by more) than large banks to a 

monetary policy tightening. 

Kashyap and Stein (2000) extend their analysis of the relative ease with which banks can raise uninsured 

deposits following a monetary policy tightening, noting that the bank loan response will also differ depending on 

the liquidity position of the bank. A bank that finds it relatively costly to raise uninsured deposits but that has 

large securities holdings has the option of adjusting to the shrinkage of reservable deposits by selling some of its 

securities, while a less liquid bank may be forced to shrink its loan portfolio by a greater degree. In a large 

cross-section of banks, they find evidence that the loan portfolios of smaller, more illiquid banks are the most 

responsive to monetary policy shocks. 

Campello (2002) distinguishes among these smaller banks based on whether the bank is affiliated with a large 



 

 

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multibank holding company, finding that the lending of small banks that are affiliated with large multibank 

holding companies reacts less to a tightening of monetary policy than does the lending of similar small 

(standalone) banks that are not affiliated with multibank holding companies. Although this evidence indicates 

that small banks affiliated with multibank holding companies are better able to insulate their lending from a 

tightening of monetary policy, the extent to which this is due to the channeling of internal holding company 

funds to bank subsidiaries rather than due to the fact that large multibank holding companies have easier access 

to external funds is not clear. Campello tries to address this issue by using capital-to-asset ratios to distinguish 

among bank holding companies.  Kishan and Opiela (2000) use the capital-to-asset ratio as the proxy for a 

bank's ability to raise uninsured deposits, finding that the loan portfolios of well-capitalized banks are less 

sensitive to monetary policy shocks than are those of poorly capitalized banks of the same size. However, for 

reasons discussed below, capital-constrained banks may behave differently for reasons other than their ability to 

raise uninsured deposits. 

Holod and Peek (2007) utilize the distinction between publicly traded and non-publicly traded banks to classify 

banks by the ease with which they can access external funds. They find that after controlling for size, 

capitalization, and other factors, the loan portfolios of publicly traded banks shrink less than those of 

non-publicly traded banks when monetary policy tightens due to the banks' ability to raise external funds, 

including by issuing large time deposits. Furthermore, as one would expect, when a distinction is made between 

tightening and easing monetary policy, the estimated effect can be attributed to the effects of monetary policy 

tightening (tightening a binding constraint) rather than to monetary policy easing (possibly pushing on a string). 

Loutskina and Strahan (2009) argue that growth in loan securitization, in particular the expansion of the 

secondary mortgage market, has weakened the transmission of monetary policy through the lending channel by 

increasing bank balance sheet liquidity.  

Cetorelli and Goldberg (2012) argue that the domestic amplification of monetary policy through the lending 

channel has been mitigated by the increasing globalization of banking. Banking organizations with international 

operations are able, at least partially, to insulate themselves from domestic liquidity shocks, such as from a 

monetary policy tightening, though the cross-border operation of their internal capital markets. That is, 

multinational banks can react to a tightening of monetary policy by using internal flows of funds to offset the 

impact on their domestic banks. On the other hand, this mechanism also suggests that the total effect of the 

lending channel has been understated by focusing only on domestic lending, insofar as changes in monetary 

policy are propagated internationally through the internal capital markets of global banks. 

Peek and Rosengren (1995b) focus on the direct impact of the enforcement of capital regulations by bank 

supervisors on the ability of capital-constrained banks to lend, and thus to be able to increase loans in response to 

an easing of monetary policy. They examine the impact on bank lending of formal regulatory actions (cease and 

desist orders and written agreements) imposed on banks that experienced asset quality problems. They find that 

the enforcement actions by bank regulators included explicit capital targets that needed to be achieved over a 

short time frame. The result was an immediate and significant reduction in bank loan portfolios associated with 

the imposition of the enforcement action that persisted for some time thereafter while the bank continued to 

operate under the enforcement action. 

Hall (1993) found that the introduction of the Basel I Accord had a significant impact on bank portfolios. 

Hancock and Wilcox (1994) also find that the implementation of the Basel I Accord affected banks' willingness 

to lend. However, Berger and Udell (1994) do not find evidence that the Basel I Accord created a bank capital 

crunch. More recently, a concern raised with the proposed Basel II Accord has been that the new capital 



 

 

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regulations would magnify potential capital constraints during recessions (for example, Kashyap and Stein 2004), 

making banks less responsive to an easing of monetary policy. Thus, a very real concern with the effectiveness of 

the bank lending channel, and thus the overall effectiveness of monetary policy, is whether banks are capital 

constrained at the time of an easing of monetary policy. 

2.18 Real Effects of Shifts in Bank Loan Supply 

Given that the empirical evidence generally supports the proposition that banks, particularly those that may find 

it relatively expensive to raise uninsured liabilities, respond to a monetary policy tightening by reducing loans, 

we turn to the next link in the bank lending channel mechanism. For the reduction in bank loans to have an 

impact on economic activity, firms must not be able to easily substitute other sources of external finance when 

bank loan supply is cut back. Gertler and Gilchrist (1994) find, at a somewhat aggregated level, that the 

investment of an aggregate of small firms is more responsive to changes in monetary policy than is the 

investment of an aggregate of large firms, a set of firms that presumably is less bank dependent.  

Ludvigson (1998), comparing bank and nonbank sources of automobile loans, finds that the composition of 

automobile credit impacts automobile sales, even after controlling for the standard factors that probably impact 

automobile demand. Additional evidence at an aggregate level is provided by Driscoll (2004), who uses a panel 

of state-level data to investigate the extent to which shocks to bank loan supply affect output. Using 

state-specific shocks to money demand as an instrumental variable to address the endogeneity problem, he does 

not find a meaningful effect of loan supply shocks on economic activity at the state level.  

Ashcraft (2006), similarly basing his analysis on state-level data, attempts to exploit differences between 

standalone banks and banks affiliated with multibank holding companies in their degree of access to external 

funds in order to identify loan supply shocks related to changes in monetary policy. While he does find a 

difference between the two types of banks in their lending response to changes in monetary policy, he does not 

find a significant effect of these bank loan supply shocks on state income growth.  

Ashcraft (2005), using the cross-guarantees of two failed Texas bank holding companies as his identification 

mechanism to address the endogeneity problems, finds that the failures of healthy banks forced by the 

cross-guarantee provisions were associated with reduced local economic activity. This suggests that bank lending 

is special, insofar as it appears that other lenders (even other banks) did not fill the gap created by the sharp 

reduction in lending by the failed banks, and is consistent with an operative lending channel. 

Another approach that provides direct evidence that a reduction in bank loan supply adversely affects 

macroeconomic activity is provided by Peek and Rosengren (2000). Using the banking problems in Japan as the 

source of an exogenous loan supply shock in the United States, they are able to avoid the common endogeneity 

problem faced by studies that rely on domestic shocks to bank loan supply. Furthermore, by focusing on 

commercial real estate loans that tend to have local or regional markets, they are able to exploit cross-sectional 

differences across geographic regions to show that the decline in loans had real effects. That is, the pull-back by 

Japanese banks in local U.S. markets was not fully offset by other lenders stepping in to fill the void. Taking still 

a different tack, Peek, Rosengren, and Tootell (2003) obtain evidence of a macroeconomic effect of shifts in 

bank loan supply. They find that adverse shocks to bank health weaken economic activity in the major GDP 

components that one would expect to be most affected by bank loan supply shocks for example, the change in 

business inventory investmentwhile not impacting other major components of GDP whose fluctuations would be 

correlated with demand shocks. 

Slovin, Sushka, and Poloncheck (1993) observe that the failure of Continental Illinois Bank adversely impacted 



 

 

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borrowers that had a close banking relationship with that bank. However, this outcome did not hold if the 

Continental Illinois loan was part of loan participation unless Continental Illinois was the lead underwriter of the 

loan. In terms of the strength of the banking relationship, Petersen and Rajan (1995) note that a firm's banking 

relationship often involves both a deposit and a lending relationship. They find that the strength of lending 

relationships, as indicated by a firm holding deposits at the bank, is indicative of how extensively the firm relies 

on bank lending.  

Fields et al. (2006) argue that the value of lending relationships has diminished substantially over time, due in 

part to the further development of financial markets and the increased availability of information about 

borrowers. However, their sample includes only publicly traded firms, precisely those firms that are the least 

likely to be bank dependent. Consistent with the view of Fields et al. (2006), Gande and Saunders (2012) argue 

that the development of the secondary loan market has reduced to some extent the ‗specialness‘ of banks due to 

the weakening of banks‘ incentives to monitor borrowers. 

2.19 Adverse real-side effects of Contractionary Monetary Policy 

One important problem with monetary policies that constrains domestic credit is that they may have substantial 

adverse supply effects. The conventional view is that tight monetary policy that results in credit contraction 

causes private expenditures (especially durable goods and investment) to decline, causing a decline in aggregate 

demand, which reduces inflation. The decline in credit is also supposed to cause a reduction in the demand for 

imports, which ameliorates the current account deficit and reduces (imported) inflation. If credit contraction had 

only aggregate demand effects, then central banks could indeed control inflation by using contractionary 

monetary policy.  However, availability of credit determines the ability of firms to accumulate capital and hire 

labor. Thus, credit contraction causes a decline in capacity utilization, employment, and production. Tight 

monetary policy, which is usually associated with high interest rates and a strong currency, particularly hurts 

export-oriented sectors by undermining international competitiveness. The decline in production and exports 

causes upward pressure on the price level and deteriorates the current account, causing inflation to accelerate. 

The increase in the price level results in a decline in real credit, which causes investment and employment to 

decline further. If these supply effects are significant, contractionary monetary policy will fail to reduce and 

contain inflation. 

The inability of monetary policy to control inflation has long been recognized even in the Real Business Cycle 

school of thought. Sargent and Wallace (1981) pointed out that ―even in an economy that satisfies monetarist 

assumptions, Friedman‘s list of things that monetary policy cannot permanently control may have to be 

expanded to include inflation.‖ Friedman had argued that monetary policy could not permanently influence real 

output, employment, and real returns on assets, but that it could definitively influence inflation (Friedman, 1968). 

In practice, however, because monetary policy has both supply and demand effects, especially through the credit 

channel, contractionary monetary policy may be ineffective in controlling inflation while it has substantial 

adverse real effects. 

Blinder (1987) offers a simple theoretical framework to illustrate that the supply side effects of tight monetary 

policy through credit contraction may outweigh the demand effects on the price level. In Blinder‘s model, supply 

(y) is determined by factor utilization (F), which in turn depends on real credit (c/p) (c is nominal credit and p is 

the price level): 

yt = γ Ft-1;Ft    =   α(c/p)t;  yt = γα (c/p)t-1;  Where γ < 1; α < 1  

Aggregate demand (d) is determined by income: 



 

 

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dt = a + byt ; where 0 < b <1          (19)    

Equations 18 and 19 can be combined to yield aggregate demand as a function of real factor utilization and real 

domestic credit: 

𝑑t = 𝑎 + 𝑏𝛾𝐹t-1 = 𝑎 + 𝑏(𝑐/𝑝)t-1         (20) 

The price adjustment process is summarized in the following equation: 

Pt+1 = λ(dt – yt)               (21) 

It follows from the above relations that credit contraction decreases demand (d), which causes the price level to 

decrease, but it also decreases supply (y) which causes the price level to increase. From equations 1 and 3, the 

effects of a one percent decrease in credit may have a larger effect on supply than on demand under reasonable 

assumptions about the values of the parameters b,γ , and α : as long as b,γ ,α < 1, it follows that b, γ, α < γ α , so 

that | dy / d(c / p) | > |dx/d(c / p) |, implying that p! > 0. Under these conditions, tight monetary policy is 

stagflationary as it causes output to decline while inflation accelerates. Contractionary monetary policy arguably 

reduces inflation by reducing domestic aggregate demand. However, low aggregate demand may be a constraint 

to output expansion. In the case of SSA countries, domestic markets for goods and services are thin, which is a 

constraint to production. A contraction in bank credit to the private sector therefore depresses production. Under 

such circumstances, even if price stability were achieved, the economy may incur a high cost in terms of reduced 

investment, employment, and output. Therefore, the monetarist orientation espoused by central banks in SSA 

countries to control inflation may constrain domestic credit, which exacerbates credit rationing arising from 

market imperfections. 

In the context of SSA countries, the negative effects of contractionary monetary policy on private credit are 

exacerbated by pressure from deficit financing. Contractionary monetary policy in the context of chronic budget 

deficits automatically creates a captive market for government debt. Given that government borrowing is outside 

of the control of the monetary authority, tight domestic credit amounts to squeezing credit to the private sector, 

which has negative effects on domestic investment. 

2.20 Bank Credit and Domestic Investment 

There is a large and well established literature on the determinants of investment and methodologies for 

empirical investigation of investment behavior. A selected list includes Baddeley (2003), Chirinko (1993), 

Jorgenson (1971), Junankar (1973), and Nickell (1978). Fazzari et al. (1988) provide theoretical motivation and 

empirical evidence on the importance of credit constraints for investment at the firm level. This study focuses on 

the implications of the links between monetary policy and bank credit for investment at the aggregate level. Here, 

we derive a testable relationship between investment and monetary policy to illustrate the effects of monetary 

policy on domestic investment through bank credit to the private sector. This relationship goes beyond the 

standard situations of credit rationing (Stiglitz and Weiss, 1981) and financial repression typically examined in 

the development finance literature (McKinnon, 1973). In the case presented here, the monetary policy stance can 

be explicitly pro- or anti-domestic credit, which affects private investment. In addition to the usual interest rate 

effect, monetary policy affects investment through the quantity of credit and its overall effects on financial 

intermediation. By reducing overall financial intermediation, credit contraction depresses business investment 

and overall economic activity. 

The role of the ―state of credit‖ has been emphasized for a long time in the economic literature. Keynes (1973) 

pointed out that ―the banks hold the key position in the transition from a lower to a higher scale of activity… The 



 

 

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investment market can become congested through shortage of cash. It can never become congested through 

shortage of saving.Well-functioning domestic credit markets facilitate long-term investment by pooling resources, 

thus resolving the firm‘s problem of mismatches between revenue and expenditure flows. Credit markets also 

stimulate investment by facilitating risk sharing among investors. In particular, limited liability associated with 

credit financing makes investors more comfortable in undertaking large long-gestation investment projects. As a 

result, increased access to low-cost credit stimulates domestic investment. Therefore, the ―state of domestic 

credit‖ is an enhancing ―X-factor‖ in the capital accumulation process. The foregoing discussion suggests that a 

better credit environment, or abundant and affordable credit, is being associated with higher optimal capital stock. 

This can be formalized by the following equation: 

K*
t = a + bXt + Zt                (22) 

where X is the indicator of the state of credit and Z is a vector of other determinants of investment demand. The 

adjustment to optimal capital stock is as follows: 

ΔK t = γ (K
* 

t – Kt-1) K 6               (23) 

where γ is the flexible accelerator parameter assumed to be between 0 and 1. Gross investment, the sum of net 

investment and replacement, is given by:  

I t = ΔKt + δKt-1                 (24) 

Where δ is the depreciation rate. Combining the above three equations yields investment as a function of the 

―state of credit‖: 

1t  = aγ + bγXt +  θγZt + ( δ – γ) Kt-1           (25) 

Monetary policy also has direct effects on domestic investment through the interest rates. These will be tested 

empirically in the next section. The empirical analysis also takes into account the effects of other factors of 

private investment, notably growth, political risk and trade. Given that investment is inherently irreversible, 

undertaking a new investment project carries a certain degree of risk (Bernanke, 1983; Dixit and Pindyck, 1994). 

This risk will be higher the higher the level of economic and political uncertainty. Using various measures of 

economic and political instability, some studies have found that risk has a quantitatively significant negative 

effect on investment. 

International trade may have a positive or a negative effect on domestic investment. If the increase in trade is 

accompanied by a reduction in the cost of imported inputs and more access to export markets, then trade will 

stimulate domestic investment in the relevant sectors. However, trade openness may depress domestic private 

investment due to foreign competition. A number of studies have found that openness exerts a positive effect on 

domestic investment (see Ndikumana (2000) for evidence on sub-Saharan African countries). However, an 

important empirical issue is the difficulty in identifying the exact channels through which the effects of trade 

openness on investment actually operate. Another problem is measurement of openness. In particular, due to the 

lack of consistent data on trade policy indicators, empirical studies typically rely on measures of trade outcomes 

(imports plus exports) as proxies of trade policy indicators. In practice, however, a country may experience an 

increase in trade without any change in trade policy, as in the case of a resource-rich country during commodity 

price hikes. Conversely, trade policy reforms aimed at promoting exports (e.g., reduction in export duties) may 

not necessarily result in expansion of exports, especially if a country‘s products are not price elastic as is the case 

of agricultural products. These caveats must be kept in mind while interpreting the results on measure of 

openness. 

 



 

 

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2.21 Theoretical Framework:  Theories of Financial Intermediation The Perfect Theory of Financial 

Intermediary 

Three pillars are at the basis of the modern theory of finance: optimality, arbitrage, and equilibrium. Optimality 

refers to the notion that rational investors aim at optimal returns. Arbitrage implies that the same asset has the 

same price in each single period in the absence of restrictions. Equilibrium means that markets are cleared by 

price adjustment through arbitrage at each moment in time. Levine et al (2000). In the neoclassical model of a 

perfect market, e.g. the perfect market for capital, or the Arrow-Debreu world, the following criteria usually must 

be met:  

 No individual party on the market can influence prices; 

 Conditions for borrowing/lending are equal for all parties under equal circumstances; 

 There are no discriminatory taxes; 

 Absence of scale and scope economies; 

 All financial titles are homogeneous, divisible and tradable; 

 There are no information costs, no transaction costs and no insolvency costs; 

 All market parties have ex ante and ex post immediate and full information on all factors and events 

relevant for the (future) value of the traded financial instruments. 

The Arrow-Debreu world is based on the paradigm of complete markets. In the case of complete markets, 

present value prices of investment projects are well defined. Savers and investors find each other because they 

have perfect information on each other‘s preferences at no cost in order to exchange savings against readily 

available financial instruments. These instruments are constructed and traded Costless and they fully and 

simultaneously meet the needs of both savers and investors. Thus, each possible future state of the world is fully 

covered by a so-called Arrow-Debreu security (state contingent claim). Also important is that the supply of 

capital instruments is sufficiently diversified as to provide the possibility of full risk diversification and, thanks 

to complete information, market parties have homogenous expectations and act rationally. In so far as this does 

not occur naturally, intermediaries are useful to bring savers and investors together and to create instruments that 

meet their needs. They do so with reimbursement of costs, but costs are by Definition an element – or, rather, 

characteristic – of market imperfection. 

Therefore, intermediaries are at best tolerated and would be eliminated in a move towards market perfection, 

with all intermediaries becoming redundant: the perfect state of disintermediation. This model is the starting 

point in the present theory of financial intermediation. All deviations from this model which exist in the real 

world and which cause intermediation by the specialized financial intermediaries are seen as market 

imperfections. This wording suggests that intermediation is something which exploits a situation which is not 

perfect, therefore is undesirable and should or will be temporary. The perfect market is like heaven, it is a 

teleological perspective, an ideal standard according to which reality is judged. There are different views on how 

the financial structure affects economic growth exactly Levine (2000). 

 The bank-based view holds that bank-based systems – particularly at early stages of economic 

development – foster economic growth to a greater degree than market-based systems. 

 The market-based view emphasizes that markets provide key financial services that stimulate 

innovation and long-run growth. 



 

 

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 The financial services view stresses the role of banks and markets in researching firms, exerting 

corporate control, creating risk management devices, and mobilizing society‘s savings for the most 

productive endeavors in tandem. As such, it does regard banks and markets as complements rather than 

substitutes as it focuses on the quality of the financial services produced by the entire financial system. 

 The legal-based view rejects the analytical validity of the financial structure debate. It argues that the 

legal system shapes the quality of financial services La Porta et al., (1998).  

The legal-based view stresses that the component of financial development explained by the legal system 

critically influences long-run growth. Political factors have been introduced too, in order to explain the 

relationship between financial and economic development (Zingales, 2000).  

2.22 Modern Theories of Financial Intermediation 

In order to give firm ground to our argument and to illustrate the paradox, we will first review the doctrines of 

the theory of financial intermediation. These are specifications, relevant to the financial services industry, of the 

agency theory, and the theory of imperfect or asymmetric information. Basically, we may distinguish between 

three lines of reasoning that aim at explaining the raison d‘être of financial intermediaries: information problems, 

transaction costs and regulatory factors. 

First, and that used in most studies on financial intermediation, is the informational asymmetries argument. 

These asymmetries can be of an ex ante nature, generating adverse selection, they can be interim, generating 

moral hazard, and they can be of an ex post nature, resulting in auditing or costly state verification and 

enforcement. The informational asymmetries generate market imperfections, i.e. deviations from the neoclassical 

framework. Many of these imperfections lead to specific forms of transaction costs. Financial intermediaries 

appear to overcome these costs, at least partially. For example, Diamond and Dybvig (1983) consider banks as 

coalitions of depositors that provide households with insurance against idiosyncratic shocks that adversely affect 

their liquidity position. Another approach is based on Leland and Pyle (1977). They interpret financial 

intermediaries as information sharing coalitions. Diamond (1984) shows that these intermediary coalitions can 

achieve economies of scale. Diamond (1984) is also of the view that financial intermediaries act as delegated 

monitors on behalf of ultimate savers. Monitoring will involve increasing returns to scale, which implies that 

specializing may be attractive. Individual households will delegate the monitoring activity to such a specialist, i.e. 

to the financial intermediary. The households will put their deposits with the intermediary. They may withdraw 

the deposits in order to discipline the intermediary in his monitoring function. Furthermore, they will positively 

value the intermediary‘s involvement in the ultimate investment (Hart, 1995). 

Also, there can be assigned a positive incentive effect of short-term debt, and in particular deposits, on bankers, 

for example, Qi (1998) and Diamond and Rajan (2001) show that deposit finance can create the right incentives 

for a bank‘s management. Illiquid assets of the bank result in a fragile financial structure that is essential for 

disciplining the bank manager. Note that in the case households that do not turn to intermediated finance but 

prefer direct finance, there is still a ―brokerage‖ role for financial intermediaries, such as investment banks. Here, 

the reputation effect is also at stake. In financing, both the reputation of the borrower and that of the financier are 

relevant. Dinç (2001) studies the effects of financial market competition on a bank reputation mechanism, and 

argues that the incentive for the bank to keep its commitment is derived from its reputation, the number of 

competing banks and their reputation, and the competition from bond markets. These four aspects clearly 

interact. 

 



 

 

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2.23 An Alternative Approach of Financial Intermediation 

When information asymmetries are not the driving force behind intermediation activity and their elimination is 

not the commercial motive for financial intermediaries, the question arises which paradigm, as an alternative, 

could better express the essence of the intermediation process. In our opinion, the concept of value creation in 

the context of the value chain might serve that purpose. And, in our opinion, it is risk and risk management that 

drives this value creation. The concept of value creation, introduced by Michael Porter (1985), can be seen as a 

dynamic extension of the theory of industrial organization, in the tradition of Joseph Schumpeter. It represents 

the other side of the coin, which glitters in the theory of the firm: transaction costs are incurred to create value. It 

is amazing that the value added approach, now widely recognized and applied in the literature on business 

organization, management and finance describes the value creation process in banking in his book ―Competitive 

Strategies in European Banking‖, making reference to Porter. However, he does not elaborate on this concept to 

create an alternative to the existing paradigm of financial intermediation. Nor does he go into depth to explain 

the basic process of value creation by financial intermediaries. David Llewellyn‘s concept of contract banking is 

also based on the value chain idea (Llewellyn, 1999). But here too, there emerges no alternative for the 

mainstream view on financial intermediation. 

2.24 Theories of Monetary Policy 

 The Keynesian Monetary Policy  

In the Keynesian monetary theory, an increase (or decrease) in money supply is attributed to the open market 

purchase (or sale) of government debt instruments by the central bank. Interest once government decides to enter 

the market it usually purchases or sells securities on a large scale (Afolabi, 2003). If the intention is to stimulate 

a sluggish economy government repurchases securities on a large scale and injects cash into the economy to 

increase aggregate demand for goods and services, and encourage more output. If the intention is to reduce the 

high inflationary rate and create a conducive environment, government sells securities on a large scale. A large 

volume of money withdrawn from circulation and the level of money supply falls, dragging transactions 

balances of the community to a lower level. Consequently general prices fall bringing down the rate of inflation. 

Although the Keynesians define financial assets (government securities) as short-term papers, e.g. treasury bills, 

they consider long-term bonds as a representative of financial assets. Naturally the interest return on a long-term 

financial asset is expected to be higher than that of a short-term financial asset. Short-term cyclical disturbances 

or changes in short-term rates are bound to affect the long-term interest rate of a 1ong-term financial asset. 

The Keynesian theory talked about money, interest rate and their economic importance. Money has. Its value but 

it is not neutral to the general level of economic activity. Money is a generalized claim against all things that 

have economic value. 

In Keynes view the rate of interest is determined by the demand and supply money. Money supply (Ms) is fixed 

in the short-run and does not vary with interest rate. Money demand consists of: 

Md = Mt + M + MSP where 

Mt = Transactions demand for money.  

M = Precautionary demand for money.  

MSp = Speculation demand for money (Osiegbu, 2005). 



 

 

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 Adopted from Osiegbu 2005 

Note that in Fig. 1.1 r is measured on the vertical axis and Md on the horizontal, M1 + M remain inelastic with 

respect of changes in r. MSP is how people could do better holding more cash than the compensation from 

financial institutions and vice versa. Keynes provided the explanation for holding cash through the concept of 

liquidity preference. Money is the most liquid of all assets and liquidity means for ease and convenience with 

which an asset (money) can be converted from without loss of value. Liquidity preference shows that individual 

prefers to demand money to hold as cash and all demand increase unit the liquidity preference region is 1EI. 

Liquidity preference operates at very low r when the demand for money is infinitely elastic (below r) (Okereke, 

2003). 

 Empirical Review 

Gertler and Gilchrist (1994) revealed that business lending does not decline when policy is tightened. They 

concluded that the entire decline in total lending comes from a reduction in consumer and real estate loans.  

Kashyap and Stein (1995) find evidence that business lending may respond to a tightening of monetary policy. 

They find that when policy is tightened, both total loans and business loans at small banks fall, while loans at 

large banks are unaffected. The differential response of small banks may indicate they have less access to 

alternative funding sources than large banks and so are less able to avoid the loss of core deposits when policy is 

tightened.  

Gambacorta and Iannoti (2005) studied the velocity and asymmetry in response of bank interest rates (lending, 

deposit, and inter-bank) to monetary policy shocks (changes) from 1985-2002 using an Asymmetric Vector 

Correction Model (AVECM) that allows for different behaviours in both the short-run and long-run. The study 

shows that the speed of adjustment of bank interest rate to monetary policy changes increased significantly after 

the introduction of the 1993 Banking Law, interest rate adjustment in response to positive and negative shocks is 

asymmetric in the short run, with the idea that in the long- run the equilibrium is unique. They also found that 

banks adjust their loan (deposit) prices at a faster rate during period of monetary tightening (easing) (Somoye 

and Ilo, 2009).   

Van den Heuvel (2005) in his study shows that monetary policy affects bank lending through two channels. They 

argued that by lowering bank reserves, contractionary monetary policy reduces the extent to which banks can 



 

 

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accept reservable deposits, if reserve requirements are binding. The decrease in reservable liabilities will, in turn, 

lead banks to reduce lending, if they cannot easily switch to alternative forms of finance or liquidate assets other 

than loans. A study by Punita and Somaiya in 2006 on the impact of monetary policy on profitability of banks in 

India between 1995 and 2000 provided some dissenting evidence that lending rate has a positive and significant 

influence on banks‘ profitability, which indicates a fall in lending rates will reduce the profitability of the banks. 

It was also found out that bank rate, cash reserve ratio and statutory ratio significantly affect profitability of 

banks negatively. Their findings were the same when lending rate, bank rate, cash reserve ratio and statutory 

ratio were pooled to explain the relationship between bank profitability and monetary policy instruments in the 

private sector. 

Amidu and Wolfe (2008) examined the constrained implication of monetary policy on bank lending in Ghana 

between 1998 and 2004. There study revealed that Ghanaian banks lending behaviour are affected significantly 

by the countries economic also support and change in money supply. Their findings also support the finding of 

previous studies that the central bank prime rate and inflation rate negatively affect bank lending. Prime rate was 

found statistically significant while inflation was insignificant. Based on the firm level characteristics, there 

study revealed that bank size and liquidity significantly influence bank‘s ability to extend credit when demanded.  

Mohammed and Simon (2008) Somoye and Ilo (2009) investigated the impact of macroeconomic instability on 

the banking sector lending behaviour in Nigeria between 1986 to 2005. Their study revealed the mechanism 

transmission of monetary policy stocks to banks operation. The result of cointegration and Vector Error 

correction suggests a long-run relationship between bank lending and macroeconomic instability.  

3. Research Methodology 

The study uses quasi experimental research design approach for the data analysis. The approach combines 

theoretical consideration with the empirical observation and extract maximum information from the available 

data. Therefore, the research design in this study is the quasi-experimental which allows us to examine the causal 

relationship between the dependent and the independent variables. The data in this study will be sourced from 

the publications of Central bank of Nigeria Statistical Bulletin. This constitutes the time series data sourced from 

the secondary data. The model below is adopted from Toby and Thomson (2014).      

3.1 Model Specification 

Model I 

CBLA/TCBL = f (INTR, MPR, TBR, EXR, M2, LIQR) ………………………………(1) 

Model II 

CBLM/TCBL = f (INTR, MPR, TBR, EXR, M2, LIQR) ………………………………(2) 

Transforming Equation 1 to 4 above to methodological form  

CBLA/TCBL     = β0 + β1INTR + β2MPR + β3TBR + β4EXR + β5M2 + β6LIQR µ ..(3) 

CBLM/TCBL   = β0 + β1INTR + β2MPR + β3TBR + β4EXR + β5M2 + β6LIQR µ ………(4) 

Where:  

CBLA/TCBL  = Percentage of Commercial Banks Lending to the Agricultural Sector  

to Total Commercial Bank Lending. 

CBLM/TCBL    = Commercial Banks Lending to the Manufacturing Sector to Total  

Commercial Bank Lending. 

INTR    = Interest Rate 

MPR    = Monetary Policy Rate 

TBR    = Treasury Bill Rate 



 

 

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EXR    = Exchange Rate 

M2    = Broad Money Supply 

LIQR    = Liquidity Ratio 

β0   = Intercept 

β1 – β6   = Coefficient of the explanatory variable  

µ   = Error term  

In analyzing the data, and results of this study, the multiple regressions with the use of Statistical Package for 

Social Sciences (SPSS) will be used. This is used to test the hypotheses and the variables in the study.  

4. Data Presentation, Analysis and Discussion of Findings 

Table 1: Tolerance and Variance Inflation Factor (VIF) 

MODEL I TOLERANCE  VIF 

INTR .095 10.524 

MPR .138 7.249 

TBR .151 6.601 

EXR .382 2.616 

M2/GDP .523 1.192 

LIRQ .578 1.729 

Source: SPSS print out 22.0 (2017) 

Table1: Shows the tolerance Value results and variance inflation factors of the variables in the model. The 

tolerance values are less than 1.00 but above 0.1 in all the variables examined in the model with relation to 

commercial banks lending. This is inverse to the traditional level and the rule of thumb which is contrary to 

testing the multicolinearity on the tolerance. The variance inflation factor result shows that interest rate, 

monetary policy rate, Treasury bill being above 5.0 but less than 10.0 while other variables in the model are less 

than 5.0 and 10.0 as the conventional rule of thumb. 

Table 2: Colinearity Diagnostic and Durbin Watson Test 

Model  Eigen val Cond index Constant Variables Proportion 

INTR       MPR       TBR EXR M2/GDP LIQR 

1 6.321 1.000 .00 .00 .00 .00 .00 .00 .00 

2 .418 3.890 .00 .00 .00 .01 .26 .01 .00 

3 .174 6.030 .01 .00 .00 .02 .14 .09 .02 

4 .057 10.497 .00 .01 .00 .01 .11 .35 .19 

5 .015 20.543 .26 .00 .45 .22 .00 .12 .01 

6 .011 23.589 .31 .08 .05 .63 .00 .40 .17 

7. .004 39.158 .42 .91 .53 .12 .48 .03 .60 

Durbin Watson Test    1.771  

Source: SPSS print out 22.0 (2016) 



 

 

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The above table illustrates the colinearity diagnostic test result. The result shows an Eigen value that corresponds 

to the highest Cond index and the variance constant are less than 0.05 at 5% level of significance. This indicates 

the significant relationship between the dependent and the independent variables in the long run. The Durbin 

Watson statistics of 1.771 approximates 2.000 which signify that there is no serial correlation between the 

variables in the time series. 

Table 3: Effect of monetary policy on commercial banks lending to the agricultural sector: Multiple Regression 

Result 

Model Variables INTR  MPR TBR EXR  M2/GDP LIQR 

 .163 .263 -.041 .-060 -.291 -.070 

Beta () -167 191 -.035 -.637 -.299 -.115 

Corel .116 .159 -.031 -.667 -.441 -.194 

T. test .606 .839 -.160 -4.646 -2.551 -1.028 

Sig-t .549 .409 .874 .00 .017 .313 

Constant(0) 15.113 t-test 3.496 T-Sig. .002  

R .898 89.8%     

R2 .806 80.6%     

F-Ratio 18.694      

F-Sig. .000      

Source: SPSS print out 22.0 (2017) 

The estimated regression model shows that with the positive value of 15.113 as constant and regression intercept, 

the independent variables in the study positively affects the dependent variable at constant. However, the 

negative coefficient of -.041, -.060, -.291 and -.070 as β coefficient for Treasury Bill Rate, Exchange Rate, Broad 

Money Supply and Liquidity Reserve proved that increase in the variables will reduce bank lending to the 

agricultural sector of .163 and .263 as β coefficient for interest rate and monetary policy rate shows that increase 

in the variable will lead to increase on bank lending to the agricultural sector.  The correlation coefficient shows 

89.8% which means the relationship between the dependent and the independent variable is strong of the 

variables to the dependent. The R2 proved that 80.6% variation in commercial banks lending to the agricultural 

sector can be explained by variation in the monetary policy variables examined in this study. The F-statistics and 

sig. T shows that the model is significant. 

Table 4:Effect of monetary policy on commercial banks lending to the manufacturing: Multiple Regression 

Result 

Model Variables INTR  MPR TBR EXR  M2/GDP LIQR 

 -.158 .195 -.225 -.067 -.646 -.070 

Beta () -.100 .416 -.120 -.443 -.414 -.072 

Corel -.065 -.310 -.098 -.501 -.534 -.115 

T. test -.340 1.695 -.152 -3.005 -3.286 -.600 



 

 

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Sig-t .736 .102 .613 .006 .003 .554 

Constant(0) 38.924 T-Test 5.222 T-Sig. .000  

R .881 88.1%     

R2 .776 77.6%     

F-Ratio 15.601      

F-Sig. .000      

Source: SPSS print out 22.0 (2017) 

The estimated regression model shows that with the positive value of 38.924 as constant and regression intercept, 

the independent variables in the study positively affects the dependent variable at constant. However, the 

negative coefficient of -.158, -.225, -.067, -.646 and -.070 as β coefficient for Interest Rate, Treasury Bill Rate, 

Exchange Rate, Broad Money Supply and Liquidity Reserve proved that increase in the variables will reduce 

bank lending to the manufacturing sector by 1.8%, 2.2%, 0.6%, 6.4% and 0.7% while the positive β coefficient 

of .915 for monetary policy rate shows that increase will lead to increase on bank lending to the manufacturing 

sector by 9.1%.  

The correlation coefficient shows 88.1% which means the relationship between the dependent and the 

independent variable is strong of the variables to the dependent. The R2 shows that 77.6 variations in commercial 

banks lending to the manufacturing sector can be explained by the monetary policy variables examined in the 

study. The F-statistics and sig. T shows that the model is significant. 

4.1 Test of Hypotheses 

Table5: Monetary Policy and Commercial Banks Lending to Agricultural Sector 

VARIABLES T-STATISTICS  SIGNIFICANT  - T REMARK DECISION 

INTR .606 .549 Not Significant  Accept H0 

MPR .839 .409 Not Significant  Accept H0 

TBR -.160 .874 Not Significant  AcceptH0 

EXR -4.646 .000 Significant  Reject H0 

M2/GDP -2.551 .017 Significant  Reject H0 

LIQR -1.028 .313 Not Significant  Accept H0 

Source: SPSS (20.0)  

Table 6: Monetary Policy and Commercial Banks Lending to Manufacturing Sector 

VARIABLES T-STATISTICS  SIGNIFICANT  - T REMARK DECISION 

     

INTR .180 .858 Not Significant  Accept H0 

MPR -2932 .007 Significant  Reject H0 

TBR 2.619 .014 Significant  Reject H0 

EXR 7.420 .000 Significant  Reject H0 



 

 

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M2/GDP -.060 .952 Not significant  Accept H0 

LIQR -.313 .757 Not Significant  Accept H0 

Source: SPSS (20.0)  

4.2 Discussion of Findings 

The Nigerian real sector is tagged ―The Preferred Sector of the Economy‖ and government policies over the 

years has been how to promote the industry to achieve the growth of the economy. For instance, the government 

mandated commercial banks to lend significant of its credit to the real sector at a lower cost of credit prior to the 

abolition of the mandatory sectoral credit facility in 1st October, 1996. The objective was to promote the growth 

of the sector due to the importance contribution of the sector to the economic growth. Other policies through the 

commercial banks credit include the Small and Medium Equity Investment Scheme. 

The objective of this study was to examine monetary policy and commercial banks lending to the real sector of 

the economy. Findings of the study from the two regression models shows that Treasury bill rate, exchange rate, 

broad money supply and liquidity reserve have negative relationship with commercial banks lending to the real 

sectors of Nigerian economy. Interest rate was found to have a positive effect on commercial banks lending to 

the agricultural sector but was found to have a negative effect of commercial banks lending to the manufacturing 

sector. The negative effect of liquidity reserve and interest rate confirm the expectation of the results as increase 

in the variables contract bank lending ability. It also confirms the trade-off relationship between earning assets 

and liquidity reserve in the commercial banks as illustrated by Nwankwo (1998). The positive effect of the 

variables confirm the findings of Gambacorta and Iannoti (2005) who studied the velocity and asymmetry in 

response of bank interest rates (lending, deposit, and inter-bank) to monetary policy shocks (changes) from 

1985-2002 using an Asymmetric Vector Correction Model (AVECM) that allows for different behaviours in both 

the short-run and long-run. The findings of Van den Heuvel (2005) who argued that by lowering bank reserves, 

contractionary monetary policy reduces the extent to which banks can accept reservable deposits, if reserve 

requirements are binding, the decrease in reservable liabilities will, in turn, lead banks to reduce lending, if they 

cannot easily switch to alternative forms of finance or liquidate assets other than loans, Amidu and Wolfe (2008) 

who examined the constrained implication of monetary policy on bank lending in Ghana between 1998 and 2004 

and Mohammed and Simon (2008) Somoye and Ilo (2009) investigated the impact of macroeconomic instability 

on the banking sector lending behavior in Nigeria between 1986 to 2005.  

The negative effect of broad money supply on commercial banks lending to the real sectors of the economy is 

contrary to the expectation of the results and the theory of expansionary monetary policy, increase in money 

supply is expected to enhance bank lending to the various sectors of the economy. The negative effect can be 

traced to non compliance to monetary policy directives, overregulation, unattractiveness of the sectors to bank 

lending and increase in liquidity reserve or monetary policy shocks such as the withdrawal of all public funds 

from the banking sector with the advent of the Treasury single account.  

5. Conclusion and Recommendation 

5.1 Conclusion 

From the findings of the study, the study concludes as follows; 

 Interest rate has positive but not significant relationship with commercial banks lending to the 

agricultural sector but negatively related to commercial banks lending to the manufacturing sector of 

the economy. 

 Monetary policy rate have positive relationship with commercial banks lending to the agricultural sector 



 

 

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but negatively related to commercial banks lending to the manufacturing sector. 

 Treasury bill rate have negative but not significant relationship with commercial banks lending to the 

real sectors of the economy.  

 Exchange rate, Broad money supply has negative and significant relationship with commercial banks 

lending to the real sectors of the economy. 

 The study reveal 80.6% and 77.6% explained variation. The F-ratio of 15.601 and 18.694 and 

F-probability of 1% level. From the above, the study concludes inductively that there is significant 

relationship between monetary policy and commercial banks lending to the real sector of Nigerian 

economy.  

5.2 Recommendation 

From the findings of the study, we draw the following recommendations: 

 Monetary policy should be formulated to avoid negative outcome as a result of monetary policy 

measures and mismatch of bank lending with monetary policy, bank lending objectives should be 

formulated, harmonized and carefully aligned with monetary policy 

 Commercial bank lending objectives should be optimally implemented within the ambit of the monetary 

policy measures, exchange rate, interest rate, monetary policy rate etc. 

 Monetary policy and monetary policy variables such as interest rate, should answer the objective of 

bank lending to the real sector of the economy. 

 There should be policies to revamp the real sector to attract bank lending that will enhance the growth 

of the sector.  

 All policies directed towards the re-organization of the real sector should be fully implemented to 

speedy recovery of the industry. 

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