A discussion of the importance of money and credit to an economy and how major expansions and contractions of credit can develop.
Last year, we saw on the newspapers a lot of information about credit crunch and how much it affected the economy. To answer to this discussion, I will explain the importance of the money and the credit in the economy, and then I will demonstrate what can expansionand contraction of credit can develop in the economy.
In an economy, money is important. It is a synonym of a wealthy economy. More we have money in the economy, more people spend their money because the prices are low, and more the firms produce goods and so on.
As we can see on the website of the Federal Reserve, the creation of money does not require a preliminary savings. A bank does notgrant credits according to the deposits (liabilities or preliminary savings) but it is the credit placed which constitute the deposits. When a bank grants a credit to a not financial economic agent, a company or a household, the account of this one is increased by the amount of the credit. In return, he is put into debt by the amount of the credit. The bank provided to him bank money. The Bankborrows money to the Central Bank directly or thanks to intermediaries. These intermediaries help the lenders/savers (companies or pension fund who are too much money and want to invest) to meet the borrower/spenders (household or companies) who need money.
Banks are limited in their monetary creation by the fact that they have to hold certain percentage of notes and coins which could be asked bytheir customers. It is the Central Bank which controls this creation by allowing the banks to satisfy the demands of conversion of their customers. In accordance with Peter Howells and Keith Bain (Howells and Bain, 2007: 69-75), if the central bank thinks that there is too much money in the economy, she will increase her interest rates to the banks. Banks are profit- making organizations withobligations to shareholders to increase profits over time, so they will increase their interest rates because they will know that their profitability would diminish if they lend at a current rates of interest “while having to pay a higher price for reserve”.
The creation of money influences on the economy because it plays a role for the inflation or deflation of an economy. In fact, when we havetoo many credits because of low rates, households and companies borrow money from bank so then, the prices of goods increase, and we have inflation. People see that, they spend less; they borrow less money so the interest rates increase and the prices decrease, we have a deflation.
When we have an expansion of credit, which it calls credit bubbles, Banks lends money to economic agent with nonfix interest low. We have a lot of credit, so we have a lot of money in the economy, the prices are increasing, so the interest rates, and the economic agent cannot reimburse it.
When we have a credit crunch, it testifies of an automatic adjustment of markets to reach a level of liquid assets close to the balance. It is not disturbing as such.
According to the specialists of the OECD(Organization for economic co-operation and development), there are various causes of the credit crunch. For example, the world economy is in excellent health, what was translated by an excess of liquidity. From the point of view of a manager of bond capital, the economy suffers from an excess of enthusiasm (too much liquid assets, too many activities of mergers and acquisitions). The central banks thusdecide to increase the interest rates and to decrease the distribution of bank credits so that there is less currencies to inject in the economy. It was a period of weak interest rates, banks lend money without being rigorous, “feeding an insatiable demand of credits for high risk”, with the approval of not rigorous rating agencies. The market, already very complex, became incontrollable. And...
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