The commercial banking sector through its role of granting and creating credit i
ID: 1165225 • Letter: T
Question
The commercial banking sector through its role of granting and creating credit in the money creation process has a large influence on the overall macro-economy. Specifically, their directing of credit has a large impact on what type of transactions happen in the economy. The majority of loans that banks grant go towards existing assets--mainly real estate. This means that the majority of banks' credit creation goes towards unproductive transactions or transactions which don't increase GDP (The purchase and sale of existing real estate assets does not add to GDP).
1. Given that the majority of created credit goes towards existing assets, what affect do you feel this has on asset price inflation and why do you think that banks grant the majority of their loans to finance the purchase of existing assets or unproductive transactions? (Remember banks are profit maximizing firms)
Explanation / Answer
Short Answer:-
Due to recession in economy a lot of money given as loans to various has lost its value and then to cover up these banks has decided to go for more secure assets which are less variable to economies effect and then banks has decided to grant loans for real estate business as due to increasing population the demand of houses and offices were raising. people has started for more spacious offices and various other buildings. hence builders were in high demand of raising loans as in real estate business the finance of builders go blocked for a long time because it takes a substantial time to build up a project (3-5 Years) and after that they can sale that property and pay off the loans so they were in need of a long term loans which can be provided only by banks.
& if we see from banks' perspective banks were interested in secure assets so they started granting loans for real estate businesses as these are physical assets and due to recession the demand of loans by companies had reduced.
now the banks starting giving loans to real estate businesses and builders started their projects and hence a boom was created in market and there was a huge demand of real estate properties by builders so that they can develop various projects and earn a fortune and as per demand sypply curve raised demand raised the prices of existing assets and hence casued a asset price inflation.
Long Answer:-
The price stability objective pursued by central banks is generally defined in a manner that excludes asset prices. Asset price is often viewed by central banks as another macroeconomic variable which could potentially influence the inflation path either by impacting inflation expectations, or through the wealth effect on aggregate demand, or by altering the cost of funds. The relationship between monetary policy and asset prices has been conventionally analysed through the asset price channel of monetary policy transmission, under which asset prices respond to monetary policy changes and thereby may impact the ultimate policy goals relating to inflation and output. The pre-crisis mainstream view on why a central bank should not directly aim at containing asset price inflation was premised on certain sound arguments: (a) bubbles are hard to differentiate from genuine bull runs and central banks have no comparative advantage over the markets to come to any credible conclusion on the fundamental value of assets, (b) monetary policy instruments could be ineffective in preventing asset bubbles, particularly speculative bubbles, as the magnitude of the increase in interest rates would have to be large enough to be able to prick a bubble, which in turn would entail large loss of output, and (c) central banks have no mandate on asset prices. As a result, the pre-crisis emphasis in monetary policy strategies was to manage the impact of asset price developments on inflation and growth, either in a forward looking manner by anticipating the impact on inflation outlook, or by reacting to the impact on output and inflation after a bubble bursts.
In the post-global crisis period there has been an increasing emphasis on the need to explore the scope of monetary policy in responding directly to asset price developments for promoting financial stability. This renewed interest in the role of monetary policy in stabilising asset price cycles has compelled policy makers to have a re-look at the pre-crisis consensus that seemed to favour a hands-off approach to asset prices and to manage the consequences of both booms and busts in asset price cycles. The extensive debate after the global crisis does not seem to suggest that the pre-crisis consensus was blatantly fallacious. Alternative instruments at the disposal of a central bank, namely micro and macro-prudential tools, could be superior relative to the interest rate instrument, both in terms of effectiveness and minimising the overall costs to the economy. Monetary policy as a macroeconomic policy tool can ensure an environment in which prudential regulation could become somewhat more effective.
despite the limited risks from asset price cycles to macro-financial conditions relative to the advanced economies, much greater reference to asset prices is being made in the context of monetary policy. The concern relating to surges in capital flows fuelling asset prices has also provided another dimension to the debate on the dynamics between capital flows, asset prices and monetary policy. The Reserve Bank has used in the past both micro and macroprudential measures to limit the risks to financial stability from asset price cycles. It, however, has justifiably refrained from using policy interest rates with the specific intention of influencing asset prices. This paper provides empirical evidence to explain the appropriateness of such an approach and highlights that the same approach may have to continue. Expected impact of asset price trends on inflation and output, however, needs to be assessed regularly so that the scope for indirect response of monetary policy to asset price shocks could be integrated to the monetary policy framework. The monetary policy itself, which already caters to multiple objectives, should not be assigned any explicit direct role in stabilising asset prices. In this context, any policy that aims at limiting the overall pace of credit growth may have to be driven by developments such as either economic overheating or persistent high inflation, but not the perception of an asset price bubble. Similarly, if an accommodative monetary policy stance has to be sustained for a prolonged period in response to an economic slowdown or a recession, the fear of such a stance leading to asset price inflation should not trigger hasty tightening of monetary policy. For the purpose of clarity, sector specific limits on the flow of credit to asset price sensitive sectors, or even caps on direct and indirect exposure of the banking system to asset price cycles should be seen purely as prudential measures, which are different from monetary policy measures.
The empirical analysis for India exhibits that while interest rate changes cause changes in stock prices, the reverse causality does not hold. This seems to suggest that monetary policy in India does not respond to asset prices, but the asset price channel of monetary policy transmission exits. Evidence of a significant bi-directional causal relationship between credit growth and asset price trends does not provide any unambiguous result about the role of credit in asset price bubbles. This is so because of the role of a common factor; i.e. strong GDP growth coinciding with high credit growth, and the former driving the asset prices up.
Regarding housing assets, given the absence of a reasonably long time series data on house prices, this paper used a number of proxy variables. The movement in stock prices and collection of “stamp duties and registration fees” relating to housing tend to follow a systematic relationship, indicating the possibility of a broad-based asset price cycle. The housing credit demand in India appears to be sensitive to interest rate movements, which though does not validate an explicit role for monetary policy in influencing housing prices. This is because the impulse response functions reveal that monetary policy tightening leads to a moderation in credit demand over the medium-term, given the usual lags in the impact of monetary policy, which in turn gives rise to lower real output. Thus, any asset price objective attempted to be achieved through monetary policy actions may involve sacrifice of growth. Given the possibility of an adverse feedback loop, where falling asset prices and contraction in output could intensify in a spiral, direct use of monetary policy must be avoided. Moreover, asset price dynamics could be difficult to decipher for meaningful use in the conduct of monetary policy. For example, an increase in the flow of credit in the VAR model seems to lead to increase in both output and asset prices. It could be, however, particularly difficult to segregate the part of asset prices increase that might have been caused by improvement in fundamentals from the part led by speculative credit flows to asset markets. This ambiguity suggests why countercyclical regulatory policies to counter asset price bubbles could be more appropriate relative to direct use of monetary policy.