Credit Channel and Monetary Policy - Example

Credit channel and monetary policy By Student’s Name Code+ course name Instructor’s Name University Name City, State Date Credit channel and monetary policy Introduction Many researchers have conducted studies to establish the importance of credit channels when it comes to transmission of monetary policies [Eli02]. It has been determined that the ways in which monetary policies are transmitted are a major concern for the macroeconomics of any economy. Several links have been established between credit channels and the transmission of monetary policies. Two views can be identified whenever this topic is raised, which include money views and credit views. All these views rely on the functions of a central bank as a major determinant of the monetary policies of any economy. The central bank has the mandate and authority to control all the financial institutions within an economy making it a major player in determining the role of the credit channels. Any process that involves monetary circulation and policies originates from the central bank after manipulation. Many researchers have established that the clear methods of manipulating reserve equipment can be established, yet the alteration of the real levels of altering these reserves remains debatable. Most models availed have a certain percentage of rigidity that includes the rigidity of prices or at times the models limit the levels of market participation. It is for this reasons that differences between money and credit views exist. It has been established that monetary policies can be altered by changing the credit flows which implies that the two financial processes and outcomes are connected. This paper will, therefore, review the role of credit channels and monetary policies. Credit channels As stated before, changes in the monetary policies of any economy are linked to the changes in the credit flows of that economy [Ver10]. All these changes are determined at the highest level of the economy which is the central bank. Technically, the central bank plays a major role in controlling the flow of money within an economy. A central bank of an economy also serves as the primary custodian and controller of all financial institutions within the economy. As a result, all financial institutions have an obligation to rely on the policies developed by the central bank. Monetary related issues such as determination of interest rates are a primary function of the central banks. Legal reserve requirements play a crucial role in ensuring that the monetary authorities have access to certain amounts of funds, which in turn are used to determine the amounts to be maintained by the banks. When banks take a step to expand lending which can increase the spending ability of the borrowers in a given economy. When banks lower lending, the spending capacity of the borrowers reduces since they have little access to borrowed money. Alternatively, interest rates as manipulated by the central bank have more or less similar effects. When banks lower the interest rates in a given economy, borrowing rates tend to increase, but it may not imply that many people may have access to the borrowed money. When interest rates are lowered, many people are attracted to borrow money and in some economies, it has been identified as a method of encouraging economic growth. When the interest rates are increased, borrowing rates significantly reduce, which may also affect the circulation of money within the economy. High-interest rates have been cited to slow economic growth as well as entrepreneurship. According to Bayangos (2010) credit channels of monetary policies have a greater effect on the monetary policies that an economy adopts. The impacts of this approach affect the aggregate demand and output but are influenced by several underlying factors. One important factor to consider is that most banks make profit out of the loans they give out to their customers. Without such loans, banks would be non-profit institutions, which is not the case. Whenever banks issue out loans, the customers’ payback the loans with interests, which are considered as profit. All business activities conducted by the bank rely on the interest gained after repayment of loans. It implies that when the central banks lower the interest rates within an economy, lower banks and other financial institutions often make less profit as compared to situations when the interest rates are increased. Another underlying factor is that the central bank technically has the power to limit the lending ability of the banks under its watch. The various monetary related directives developed by the central bank can enhance or limit the lending ability of the banks. For instance, some interest rates as directed by the central bank can discourage the banks from lending money to its customers. The third underlying factor is that some banks depend on businesses that have proven unable to swap credit for other financial sources. All these underlying factors imply that banks have limited control when it comes too lending and as such must adhere to the trends dictated by the monetary policies. Technically, banks lack the power to reduce the commercial papers as an option of maintaining the supply of loans. The various forms of credit channels that exist are discussed in this section. The balance sheet Channel It is impossible to explain the credit channels without considering the roles of the lenders and borrowers within an economy (Zurlinden, 2005). It is assumed that the lender lacks adequate information concerning the borrower while the borrower understands one's capacity more than the bank. Any borrower can gauge how he or she will use borrowed funds to yield a profit. Equally, the borrower understands personal abilities to repay the money borrowed. The principle agent problem has been identified as the main approach to identifying the relationship between the lender and the borrower. In this type of relationship, the lender is considered as the principle while the borrower on the other side is considered as the agent. Usual problems often detected in this relationship include the moral hazard and the adverse selection. These two are very important in the determination of the wedge balance between the internal and the external funds. It has been established that a project financed by internal funds is cheaper than a similar project financed by external funds. External funds are refundable and are further subjected to interest rates which often accumulate. On the other hand, internal funds are not refundable thus not subjected to the accumulation of interest rates. The interest rates are directly responsible for the increased cost of a project. Lenders often have to rely on the borrowers’ security that is primarily determined by the borrowers’ net worth. The higher the net worth of a borrower the lower the risk to be incurred by the lender and the vice versa is also correct. Cash flows of the borrower are also excellent determinants of the ability to control internal funds, which contributes to the gaining of premiums. Bank lending channel Balance sheet channels have been cited as more active channel than the bank lending channel as far as the credit channels are concerned [Mat05]. The balance sheet channel is determined to base on the balance sheet of the borrowers. It has been established that the balance sheet channel is inversely related to the external financing premiums. The external financing premiums tend to rise whenever the balance sheet lowers and the vice versa is also correct. It would not be true to claim that the banks have no influence in credit channels. Banks are responsible for the circulation of money in the economy which also includes the supply of credit. The role banks play in supplying the economy with credits will only affect the economy in situations where the borrowers have an alternative access to borrowed money. However, the situation is technically unattainable since only major firms have access to alternate sources of funds, which is the capital market. It implies that many other firms and individuals have to rely on borrowing from the banks. Broad credit channel Other terms that can be used to define the broad credit channel is the balance sheet effect and the alternative accelerator [Mat05]. In this channel, it is not required for the banks to establish the differences between the substituting forms of credit. The imperfections in credit market significantly play a crucial role in determining the outcomes in broad credit channels. The broad credit channels are responsible for the tightening or loosening of the monetary policies applicable to a specific economy. Two terms are often important when analyzing the credit channel, which is the net income and net worth. Net income refers to the overall income of a firm or individual considering the money earned from employment or business profit. On the other hand, the net worth refers to a firm’s or individual’s total value of assets as well as money saved in banks and other financial institutions. These duo factors play a crucial role in the determination of borrowing amounts. However, the credit channel may be affected if policies in place affect the rate of borrowing or the intention of the financial institutions to lend money. Monetary supply and interest rates policy Supply of money within an economy, as well as the interest rates, can provide banks with the basic option of determining the outcomes of an economy (Macroeconomics Policy and Financial Markets: Unit 4 Monetary Policy and Central Bank). These two parameters are used by central banks to develop policies that govern an economy. Central banks develop monetary policies as a tool for controlling the macroeconomic environment, which affects all other institutions under the central bank. Controlling money supply within an economy has a greater influence in determining the inflation of a given economy. However, most of the policies only have a goal to achieve the intermediate monetary need. The central banks may lower or increase the interest rates that financial institutions adopt and also can increase or reduce the flow of money within an economy. In the development of policies, central banks often have to achieve two primary goals which can be alternating in nature. Central banks can decide to develop a target for the money supply in the economy or interest rates on credits considered to be short term [Ver10]. Banks cannot choose to adopt the two policies at the same time which implies that credit channels play an important role in the development of policies. To ascertain this claim, many economies are unable to operate efficiently without having to borrow money, which makes the credit channel an important element. As stated before, many financial institutions would never operate without borrowing and lending. The central bank has the mandate to control the flow of money within the economy so as to regulate inflation. Policies that provide banks with a large room to increase circulation of money in the economy are a threat. While policies that reduce the flow of money within the economy are likely to slow down economic growth. Credit channels must be well understood as they have a crucial role whenever banks want to develop monetary policies. It is evident that most monetary policies rely on the credit channels where the relationship between the borrower and the lender play a major role. Role of banks in transmission of monetary policies The traditional approach to determining interest rates relied on the transmission of the monetary policies which are linked to the credit channels [Mat05]. Banks play a major role in the formulation of policies since they have total control over the reserves of a given economy. Monetary policies are therefore required to control the quantity of the outside money. According to Walsh (2003), the transmission mechanism adopts a unique approach as described in this section. Monetary policies often perform open market operations so as to enhance the development of the monetary policies within an economy. In most cases, banking industries sell securities which contribute to the reduction of reserves. The fraction in the reserves acts as an extra force propelling the banks to reduce deposits in the reserves. All these changes are meant to ensure that the balance of the reserve is maintained at all times while money continues to circulate within the economy. It implies that banks never come with decisions without considering such changes otherwise imbalances can have an adverse effect on the economy. Interest rates and other forms of financial deposits are affected by any forces likely to affect the reserves. Low supply implies that the central banks are to develop policies characterized by an increase in the interest rates. The same criteria apply to situations where the supply of alternative assets rise thus forcing a significant rise in the interests of linked to the alternative assets. Conclusion Credit channel has a greater contribution to the development of the monetary policies of any given economy. This paper has identified the central banks as the major institutions responsible for the development of the monetary policies to be adopted in any economy. It has been established that central banks have the primary role of making two types of policies which relate to money supply or interest rates. These two policies are often developed basing on the credit channels available in a given economy. Central banks have a challenge of maintaining the flow of money in the economy without causing inflation. At the same time, the central banks have to establish an interest rate that would ensure the circulation of money in the economy is sustainable. The third challenge is to establish a balance in the reserves which is also sustainable to the economy. All these three challenges are linked to credit which implies that credit channels play an important role in the development of monetary transmission mechanism. Bibliography Bayangos, V. B., 2010. Does the bank credit channel of monetary policy matter in the Philippines? . Retrieved from Third Annual Asian Research Network Workshop : http://www.bis.org/repofficepubl/arpresearch201003.12.pdf Krylova, E., 2002. The Credit Channel of Monetary Policy: Cse of Australia. Retrieved from Economic Series: https://www.ihs.ac.at/publications/eco/es-111.pdf Macro-economics Policy and Financial markets: Unit 4 Monetary Policy and Central Bank. (n.d.). Retrieved from Macroeconomic Policy and Financial Markets. Walsh, C. E., 2003. Monetary Theory and Policy, Part 5; Parts 199-216. MIT press. Zurlinden, M., 2005. Credit in the monetary transmission mechanism: An overview of some recent research using Swiss data . Retrieved from Swiss National Bank Economic Studies: http://www.snb.ch/n/mmr/reference/economic_studies_2005_01/source/economic_studies_2005_01.n.pdf Read More