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January/February 1994, 
Vol. 76, No. 1
Posted 1994-01-01

Financial Innovation Deregulation and the "Credit View" of Monetary Policy

by Daniel L. Thornton

As analysts search for explanations for the protracted recovery from the last recession, a great deal of attention has been focused on the "credit view” of monetary policy, which argues that monetary policy affects the economy through the direct effect of policy actions on the supply of depository institutions’ credit. Daniel L. Thornton outlines the credit view and argues that the conditions for it are stringent. He then argues that financial innovation, deregulation and changes in the structure of reserve requirements during the past decade or so should have significantly weakened, if not eliminated, the bank credit channel of monetary policy. Thornton investigates the direct link between monetary policy actions and bank lending. Consistent with his previous analysis, he finds evidence of a weak and deteriorating relationship between Federal Reserve actions and the supply of bank credit. Thornton’s analysis suggests that the removal of reserve requirements on a very large proportion of banks’ sources of funds since 1980 has eliminated any direct relationship between the Fed’s actions and bank credit. He concludes that there is little reason to suspect that monetary policy works through the bank credit channel, if it ever did, and he considers why interest in the bank lending channel appears to have been rejuvenated at just the time when justification for it has eroded.