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). Write at least two paragraphs answering the following questions: 1. Given that the majority of created credit goes towards existing assets, what affect do you feel this has on asset price inflation?

Answer 1

Asset price inflation has often been followed by an asset price crash, a sudden and usually unexpected fall in the price of a particular asset class. Examples of asset price crashes include Dutch tulips in the 17th century, Japanese metropolitan real estate and stocks in the early 1990s, and internet stocks in 2001. It was also a contributory factor in the 2007 subprime mortgage financial crisis

It is crucial that central banks and regulatory authorities be aware of effects of asset price inflation on the stability of the financial system. Lending activity based on asset collateral during the boom is not safe for lenders when the boom collapses. One way that authorities can curb the distortion of lenders' portfolios during asset price booms is to have in place capital requirements that increase with the growth of credit extensions collateralized by assets whose prices have escalated. If financial institutions avoid this pitfall, their soundness will not be impaired when assets backing loans fall in value. Rather than trying to gauge the effects of asset prices on core inflation, central banks may be better advised to be alert to the weakening of financial balance sheets in the aftermath of a fall in value of asset collateral backing loans.