Analytics of Credit Policy
There are basically four different mechanisms through which monetary policy influences the price level and the national income. These are:
(i) Interest Rate Channel – Interest rates increases the cost of capital and real cost of borrowing for firms with the result that they cut back on their investment expenditures. Similarly, general public facing the heat of high interest rate cut back on their purchase of homes, cars, air-conditioners and other goods. So, a decline in aggregate demand results in the decline in aggregate output and goods.
On the other hand, decrease in interest rates has the opposite effect of decrease in cost of capital of firms and cost of borrowing for households.
(ii) Exchange Rate Channel – Appreciation of the domestic currency makes domestically produced goods more expensive compared to foreign-produced goods. The reason is that import from countries outside India will become cheaper and it will make the goods produced in India dearer in comparison. This will cause the net export to fall (because expensive good produced in India will have to be sold at a higher price and it will find few takers outside India). Consequently, domestic output and employment will also fall.
(iii) Quantum Channel (relating to money supply and credit) –Two things are worth mentioning in this regard – the bank lending (credit) channel and the balance sheet channel. Credit channel operates by altering the access of firms and households to bank credit. Most of the business organizations depend on bank loans for their borrowing needs. To restrict the flow of credit in times of inflation, the RBI sells government securities to commercial banks and the public and squeeze money from them. This makes the firms which are dependent on bank loans to cut back on their spending on investment. This will diminish aggregate output and employment following a reduction in money supply.
Now, we shall look at how the balance sheet channel works. The direct effect of monetary policy on balance sheet is that it will show the interest cost and increase in payments through loan repayments. An indirect effect is that the same increase in interest rate works to reduce the capitalized value of the firm’s fixed assets. This will also raise the company’s cost of capital and consequently, precipitate reduction in production and output.
(iv) Asset Price Channel – The standard asset price channel indicates that changes in credit policy effects output, employment and inflation. An increase in interest rates in debt securities makes them more attractive to investors than equity. This leads to a fall in the share prices which resulted in the consequent fall in the consumption, production and employment. These also affect the overall financial wealth of the investors.
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