Does Directed Lending Affect Monetary Policy Transmission? - Evidence from India

This paper presents new quantitative evidence using bank and firm level balance sheet data that suggests that India’s Priority Sector Lending (PSL) policy leads to greater transmission of monetary policy by banks if these banks are forced to change lending patterns in response to the policy (constrained banks). The strengthened transmission is, however, limited to loans to the non-priority sector. The paper also develops a theoretical framework to motivate these results. The PSL policy is viewed as an ad-valorem, implicit tax faced by constrained banks. This implicit tax rate falls in response to expansionary monetary shocks, causing a disproportionate increase in loans to the non-priority sector in response to a bank level portfolio re-optimization.