2.19. Bank credit and
transmission of monetary policy
For modern industrial countries the usual point for a
discussion of monetary transmission channels is the effect of monetary on
interest rates. Policy changes are transmitted from interest rates to aggregate
demand through various channels, first, increase in interest rates reduce the
expenditure of private non financial sector by raising the cost of obtaining
funds. Second, expenditure of private non financial sector is curbed by
negative quantities and land.
Third, interest rates affect the exchange rates and stimulate
the economy by changing the international price competitiveness of domestic
firms. These combined channels of monetary policy have become known as
«money view» of the monetary policy. (Carlos Serrano, 2001: 65).
Several conditions must be presented simultaneously for a bank
credit channel of monetary policy to operate (Kashap and Stein, 1994:
278).first, monetary policy must be able to affect the total volume of bank
intermediation (securities and loans).
Reserve requirement impose on deposit liabilities are argument
for monetary control, but not all bank liabilities are subjected to reserve
requirements. Banks can borrow (CDs, equity, bonds loans) to finance
intermediation. Even if bank credit is special, the leverage of monetary policy
over bank lending may be limited. (Romer, 1990: 51).
According to (Gorton and Pennacchi, 1993: 333), the increase
in research on a credit channel for monetary policy can be attributed to four
main motives: 1) Desire for new policy instruments in addition to the
traditional instrument money supply or interest rates.
They argued that, a bank credit channel might allow central
bank actions to affect the real spending of borrowers directly and improve the
trade-off between inflation and output objectives, or exchange rate and
domestic economic objectives. This concept of credit controls is reminiscent of
policies used in many countries. 2) Reduced the share of bank credit in the
total amount of funds available to the private sector.
Thonton (1994: 71) and Ceccetti (1995: 30), contend that, if
the economic effect of monetary policy depends on the influence that the
central bank has on the lending behavior of commercial banks, monetary policy
may be in danger of losing its effectiveness.
Furthermore, some authors have argued that deregulation,
innovation and global integration of financial market tend to reduce the
influence of central bank on market interest rates. While bank credit becomes a
reduced factor in funding the private sector, central banks may increasingly
have to rely on bank credit channel to affect the economy. 3) To examine the
credit channel is to develop a more reliable information variable for monetary
policy. The experience in many countries is that the short-run relationship
between money aggregates and the economy tends to breakdown time to time. If
the credit channel is important, bank credit aggregates may be more reliable
indicators of monetary policy effects than money aggregates (Friedman, 1983:
353), changes in the way banks create deposit money may provide useful
information on the relationship between money and economy. 4) Use of credit
channel is strengthened the case for the proposition that monetary policy
affects the real economy. Despite a large body of statistical evidence in favor
of short run real effects of monetary policy, the transmission mechanisms
remain unclear.
It has remained a somewhat troublesome proposition that
relatively small changes on real interest rates cause such pronounced effects
on investment, consumer expenditure (Bernanke and Gertler, 1995).
Bernanke and Blinder (1988: 78), Greenwald and Stiglitz (1990:
149) show how interaction with bank credit increases the real effect of
monetary policy, while at the same time mitigating the effect on market
interest rates.
Bernanke and Blinder (1988: 79) argue that, uses of credit
channel dependent on the relationship between money effects and bank credit;
effects on economic activity.
Money and bank credit are two sides of the same balance sheet
and bank loans are the main source of the expansion of the deposit money in the
modern fractional-reserve banking systems. The money view of the transmission
of monetary policy contends that, as a first approximation, the volume and the
composition of bank credit is important.
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