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?

2. 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)

Answer 1

Commercial banks has the power of credit creation by advancing loans and purchasing securities which depends on the amount of cash with the bank,cash reserve ratio,excess reserve, external drain,banking habits and willingness of customers to borrow.Asset price inflation refers to rise in price of assets.Commercial Banking system as a whole can make multiple expansion of credit on the basis of their excess reserve.Excess reserve is created by financial instruments such as bonds, shares and real estate.Let ∆Z is excess reserve, r is the minimum reserve ratio.
Total credit creation= ∆K=∆Z+(1-r)∆Z+(1-r²)∆∆Z+...
Banks grant majority of their loans to finance the purchase of existing assets rather than unproductive transaction.Since the expansion of assets increase the production,which may lead to increase its profit.With every business transaction and profit banks are involved.Hence banks will also have profit making chances whereas in unproductive transaction chances of profit making is comparatively low.