The monetary transmission mechanism involves 2 sections, it describes how the changes in the financial sector leads to a change in the aggregate demand, real GDP and the price level. (P??tursson, 2001) The monetary transmission mechanism consists of 4 different channels; they are the interest rate channel, credit channel, exchange rate channel and expectation channel. In previous years, the central banks have been able to control inflation through the implementation of the monetary policy beginning with the money supply such as buying or selling government securities in the financial markets . It is the standard approach to the transmission mechanism. By decreasing the money supply, it would be able to increase the interest rate, affecting the different channels and would cause a decrease for money demand because more people would be spending less. Thus, decrease in aggregate demand and lower inflation. (Mishkin, 1996)
Alternatively, the current practice that central banks are using to control inflation is through the interest rate channel because it plays a very dominant role in the transmission mechanism. By targeting the interest rates directly, which is the official rate also known as the repo rate on repurchase agreements, the central bank is able to control the amount of money being injected into the economy as financial institutions requests loans from the central bank through repurchase agreements. (Bech, Klee, & Stebunovs, 2011) When central banks are able to change the official rate (short-term interest rates) it sends an impulse that is transmitted though out the transmission mechanism, financial institutions will adjust their overall rates (long-term interest rates) like rates on deposits, mortgages and loans that are set to customers. Hence, influences aggregate demand and inflation. (ECB, 2010) Moreover, the asset price channel such as bonds and equities will be affected; a rise in interest rate will cause asset price to fall and decreases the consumers’ wealth, aggregate demand and inflation. Also, there would be an appreciation of exchange rate. It will be more expensive to purchase domestic good and cause net export demand to fall. Also, changes in the official rate will influence the expectation channel a fall or increase in the interest rate will influence the consumers to consumers save today and consume tomorrow or Vis versa (Monetary Policy Committee, 2014)
However, when the central bank set the interest rate very low, it will cause the transmission mechanism to break. This can be explained through the credit channel, which consists of 2 sub-sections: the bank lending channel and the balance sheet channel. The bank lending channel refers to the supply of bank loans to the economy. Also, the balance sheet channel refers to the balance sheets of the borrowers. (Bernanke & Gertler, 1995) When the economy enters a deflation associated with a large amount of debt, it causes the bank’s balance sheet to be fragile due to uncontrolled lending to subprime borrowers , creating non-existent loans. (The Economist, 2012) Moreover, because of asymmetric information on their credibility, when households face a bad income shock, becoming unable to repay their debt. Banks start to sell off households’ collateral for the repayment of debts such as mortgages. Alternatively, with a large amount of houses to be sold at the same time, it would cause housing prices to fall. (Mishkin, 1996) Central banks would lower the official rate to stop asset prices to fall any further because it would be more difficult for banks to receive back their repayments which causes liquidity problems as there is a lack of supply of credit between banks and supply loans to the economy. This shows the bank lending channel breaking down.
According to the figure 1, there is a steady inverse relationship between the rates and new home sales until 2007 . Where there is a sharp decrease in new home sales with the rates remained low. (Roche, 2012) Also, even as mortgages dropping, it wasn’t attractive if the house prices are not expected to increase during the crisis. (The Economist, 2012)
Nevertheless, central banks would adopt the Zero Interest Rate Policy (ZIRP) to drag down all interest rates hoping that banks being able lend to the private sector at a lower interest rates. However, interest rates paid by households and companies still remained high. (Varoufakis, 2012) Households and firms would not want to incur more debts than they already have. Banks wouldn’t want to generate more loans due to adverse selection and moral hazard of household. This shows the interest rate channel breaking down. (Mishkin, 1996)
In the financial crash of 2008, banks have stopped their lending to each other and to the economy, in fear that they will not receive repayment. However, the Euro Central Bank (ECB) has implemented the ZIRP thinking that it would have an optimistic impact on the economy, for banks to lend to businesses. (Varoufakis, 2012)This is because with the official rate at the Zero-lower Bound (ZLB), it would be cheaper for banks to borrow from the central bank and lend them to businesses at lower interest rates. This can be mainly felt by the core countries. However, has been ineffective for peripheral countries due to the disadvantage of the transmission mechanism (Forest, 2013) and different interest rates set by the private banks. Referring to figure 2, the corporate lending rates between the rates set by the ECB has a massive difference for the peripheral countries (GIIPS)
Additionally, although official rates have been lower, interest rates set by the private banks still remained high and with the lack of credit supply for banks to borrow from each other, the transmission mechanism remains broken in the interest rate and credit channel. Also, this leads to small-medium enterprises (SMEs) are also affected as they depend on bank funding to finance their businesses. (Kaminska, 2012) The interest rates on SMEs were higher in the peripheral countries than the core countries. (Refer to figure 3) Besides, it was much difficult for the SMEs to obtain funding; many loans were rejected compared to larger firms. (Refer to figure 4) (Al-Eyd & Berkmen, 2013)
Moreover, SMEs are the main solution to solve unemployment as they create job opportunities. (Prosser, 2014) In the economy, if SMEs are unable to get their loan approved it will cause them to close down and exit from the market. This causes other negative effects such as an increase in unemployment, this cause a decrease income for households (weakness in balance sheet channel) and causes them to be unable to make repayment of loans back to the banks.
Additionally, before Japan Crisis in 1990s, Japan implemented expansionary fiscal and monetary policy. This has led to an appreciation of yen and created strong expectations of increase in the value of assets (property, equity and shares). This has led to banks abusing their power of giving out loans mostly on property related businesses, using land as collateral. However, when the asset price bubble burst, it caused the value of land to devalue and causing the loans to become non-performing loans (NPLs) and when Japan enters a deflationary period, it caused the number of NPLs to grow. (Fujii & Kawai, 2010)
BOJ have implemented ZIRP in 1999 where the policy rates were as low as 0.02% to help the economy recover from the deflation. ZIRP was ended in 2000 as there was an increase in growth of the economy. However, the policy was implemented back into the economy again to avoid deflation in March 2001 alongside the quantitative easing policy (QE) as a supportive role, with the intention of banks to increase their lending to economy and stimulate economic (Syed , Kang, & Tokuaka, 2009) However, QE serves as an unconventional policy.
QE is an unconventional policy, when it was adopted. There were already a large amount of NPLs on the balance sheet of the banks. Banks were discouraged lending to households and firms in fear of unable to receive repayment. (Syed , Kang, & Tokuaka, 2009) Besides that, the increase in liquidity of banks’ balance sheet was ineffective. According to research, the asset of banks’ went up by 14 trillion yen in March 2001 and in March 2003, the federal reserves increased by 25 trillion yen in the BOJ. This shows that there was a small increase in liquidity in economy. Banks preferred to hold their deposits in the BOJ than to hold deposits with each other as it increases the risk of default. Also, banks were required to keep 20% of their deposits with other banks but with interest rates near zero banks would rather keep deposit at the BOJ. (Bowman, Cai , Davies, & Kamin , 2011)
Additionally, similar incident also happened during the Nordic Crisis of 1990. The Nordic countries consists of Finland, Norway Sweden which went through a systemic banking crisis. The cause of this crisis was due to financial liberization which made banks to lend more with out any restrictions. (Jonung, 2007) Also, to support the implementation of a low interest rate policy and help the economy to grow. (Steigum, 2011) Besides that, with interest at low rate, it caused asset prices to rise and led to an increase in borrowing. Also, banks had adopted poor lending behaviour by overlending and ignoring the creditworthiness of the borrowers.
By comparing the Euro Zone, Japan and Nordic Crisis, we clearly see a common mistake that has been done. It is where the banks made a mistake by over expanding their balance sheet and having a positive expectation that there is repayment due to rising asset prices. Also, banks had adopted poor lending behaviour by overlending than what they have a ignored the creditworthiness of the borrowers. However, when the bubble burst, it caused many loans to go default.