JOURNAL OF APPLIED ECONOMETRICS J. Appl. Econ. 21: 275–305 (2006) Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/jae.830 HOW DO CHANGES IN MONETARY POLICY AFFECT BANK LENDING? AN ANALYSIS OF AUSTRIAN BANK DATA SYLVIA FR ¨ UHWIRTH-SCHNATTER a AND SYLVIA KAUFMANN b * a Johannes Kepler Universit¨ at Linz, Department of Applied Statistics and Econometrics, Altenberger Strasse 69, A-4040 Linz, Austria b Oesterreichische Nationalbank, Economic Studies Division, P.O. Box 61, A-1010 Vienna, Austria SUMMARY Using a panel of Austrian bank data we show that the lending decisions of the smallest banks are more sensitive to interest rate changes, and that for all banks, sensitivity changes over time. We propose to estimate the groups of banks that display similar lending reactions by means of a group indicator which, after estimation, indicates each bank’s classification. Additionally, we estimate a state indicator that indicates the periods during which the lending reaction differs from what we normally observe. Bayesian methods are used for estimation; a sensitivity analysis and a forecast evaluation confirm our model choice. Copyright  2006 John Wiley & Sons, Ltd. 1. INTRODUCTION In the present paper, we investigate whether monetary policy is propagated to the real economy by affecting the amount of credit provided by the banking system to the private sector. When monetary policy becomes restrictive, banks have to cut back on new lending because the decrease in reserves, and hence in deposits, is not fully substitutable by other financing possibilities, e.g. borrowing on the interbank market, issuing bonds, equity or certificates of deposits (CDs), due to credit market frictions on the depositors’ side (see Stein, 1998). For borrowers, on the other hand, it is also the case that a decrease in bank lending is usually not perfectly substitutable with funding from financial markets (Kashyap et al., 1993). Therefore, if firms and households mainly rely on bank finance for funding their activities, i.e. if they are bank-dependent, we will observe a decline in economic activity after restrictive monetary policy actions. This transmission channel essentially stresses the credit view of monetary policy (Bernanke and Blinder, 1988, 1992), 1 and as it describes the behaviour of the credit market’s supply side, it is usually subsumed under the term ‘bank lending channel’. If we additionally take into account that the banking system is populated by heterogeneous banks, this channel implies that monetary policy also has distributional effects. We might expect L Correspondence to: Sylvia Kaufmann, Oesterreichische Nationalbank, Economic Studies Division, P.O. Box 61, A-1010 Vienna, Austria. E-mail: sylvia.kaufmann@oenb.at Contract/grant sponsor: Austrian Science Foundation (FWF); Contract/grant number: Grant SFB 010. 1 The importance of credit markets as shock propagators was first emphasized by Fisher (1933). However, the issues raised therein definitively became neglected in research, after Modigliani and Miller (1958) established their ‘theorem’ that investment decisions of firms would not depend on financial structure. The discussion regained relevance after Mishkin (1978) and Bernanke (1983) showed that the developments in financial wealth of households and the disruptions, i.e. financial disintermediation, experienced in the loan market aggravated the real effects of the recession beginning in 1929, and led subsequently to the Great Depression. Copyright  2006 John Wiley & Sons, Ltd. Received 7 May 2002 Revised 29 August 2004