THE Credit Supply Channel of Monetary Policy Transmission Mechanism: An Empirical Investigation of Islamic Banks in Pakistan versus Malaysia

Abstract

The transmission mechanism of monetary policy is explained through the relationships

between a change in money supply and the level of real income. Monetary policy

transmits to the real sector through several different channels. Such channels include

the interest rate channel, the exchange rate channel, the asset-pricing channel, the credit

supply channel, and the bank balance sheet channel. This paper empirically investigates

the credit supply channel of monetary policy and explores the differential impact of

monetary policy on credit supply of Islamic banks in Pakistan versus Malaysia. The

robust two-step System-Generalize Method of Moments (GMM) estimator is applied

on an unbalanced panel dataset over the period 2005-2016. While estimating the effects

of three alternative measures of monetary policy on banks’ credit supply, several bank-

specific variables are included in the specification as control variables. We provide

strong evidence on the existence of credit supply channel in the baseline models for

both countries and differential impact of monetary policy through Islamic banks in

Pakistan versus Malaysia in the extended models. Our findings suggest that there is

a vital need to consider the nature of Islamic banks while devising the instruments

of an effective monetary policy in countries with dual banking system like Pakistan,

Malaysia, Indonesia, Bahrain, Saudi Arabia, Qatar and others.