Imperfections of the Credit Markets - Essay Example

NONE The credit market is a market for the exchange of short-term commercial paper and debt securities. The government and companies will allow investors to buy these instruments in order to raise fund. The credit market encompasses trading on credit related products and mostly non-exchange traded contracts (Woodford, pp, 21-44). Imperfections of the credit markets The imperfections of the credit market provide the key to understanding the important issue in business growth, development, and cycles. The credit market has many frictions that work against it to produce an imperfect market. An example of asymmetric information. Asymmetric information refers to a situation where participants in a particular market have different information. In the case of credit markets, borrowers may know more information regarding their credit worthiness more than the lenders. Another element that brings about imperfection is limited commitment. It refers to situations where parties to a particular contract are not willing to fulfill their obligations. Lenders will usually use collateral to offset the adverse effects of limited commitment. One of the main effects of the two imperfections is that borrowing can only take place against collateral, such as buildings, land, and machinery. The case will affect the ability of the households and firms to borrow because of changes in the value of collateral (Filardo et al. pp, 11-37). Economists have consistently made the assumptions that the credit market is perfect. However, this assumption is not accurate because of the frictions that take place in the market. The frictions mentioned above are of particular interest to any economist. The diverse effects that are they impact on the market cannot be. It is why there is a need for an economic framework that embraces intermediation because frictions can impede the crucial supply of credit in the market. An assumption that the market is perfect would be against the realities of the economy. The effects of frictions are in various economic fields such as the investment decisions, consumption/savings behavior, economic growth and the transmission of monetary policy (Bernanke et al. pp. 17-51). Incorporation of credit market imperfections in macroeconomic models Changes in the credit market condition will result in the amplification and propagation of the initial effect of first real or monetary shocks. Shocks are unexpected and unpredictable events that affect an economy these factors may be positive or negative. Exogenous factors have an impact on endogenous economic variables; the economic variables that respond are output and employment. The market imperfections will provide the key to understanding the important issues in business growth, cycles, and development. The market imperfections affect the economy in matters of savings and consumption behavior. The commodity market might also be affected by the monetary policy shocks with prices of goods increasing. There are various channels through which monetary transmission occurs. Interest rate channel is a means of transmission and operates through the impact of monetary shocks on liquidity conditions and real interest rates. Although this mechanism is a well-established mechanism of monetary transmission, it might not account the extent to which the output fluctuations vary in an open economy. The exchange rate channel works through the impact of monetary developments on exchange rates and aggregate demand and supply. The asset price is a channel of monetary transmission and operates through the monetary shocks on real estates, equity shares, and other domestic assets. The effectiveness of monetary transmission mechanisms varies and changes over time. It depends on structural financial and economic conditions. Variations in the short term interest rates and other policy instruments alter the firm’s capacity for fixed investment spending. The impact can be scrutinized via balance sheet effects, and household consumption is affected through wealth effects (Bernanke et al. pp. 27-48). Theoretical basis for the view that acknowledging credit market imperfections will resolve the anomaly in question Monetary policy shocks have contributed to various volatilities of the economic aggregates. Exchange rates are particularly affected by volatilities. Monetary policies may not only result in an effect on the state of the home economy but also an effect on the foreign economy. Though the use of vector autoregression the responses to policy shocks can be. The following is a discussion of the various responses. The following facts are in the analysis of the response of the different variables to macroeconomic policies. A monetary constraining is by a sustained decline in the price and GDP levels. The final demand of the market will absorb the initial impact of monetary tightening. The fixed business investments will eventually fall to monetary tightening. It also lags behind those of consumer durables and housing (Gertler, pp, 63-74). Response of final demand and inventories The final demands and inventories are measured relative to the trend. Response of spending component Tightening in monetary policies causes a drop in residential investment. Business fixed investments also reduce due to the monetary tightening. The durable and non-durable components are also affected with the non-durables reacting more than the durables. Response to output, prices, and federal funds rate Response to output, prices, and federal funds rate How imperfections in credit markets interact with asset price volatility in the Determination of macroeconomic outcomes. Monetary policy movements are not sufficient enough all by itself to handle the effects of busts and booms in asset prices. The movement of asset prices creates distortions in the economic activity because of their effect on the ability to finance investment by managers. There is an existence of non-fundamental asset price movement. However, it is recognized that there may occur price booms in collaboration with changes that underlie economic fundamentals. Assets will reflect the underlying expectations of the growth of the economy with their price movements distorting the economic activities through financing mechanism. An Economy of efficient credit markets and without regulatory distortions, movements in asset prices simply reflect changes in underlying economic fundamentals. Low levels of inflation or periods, monetary stability, are also implicated in the inflation of assets. It is that sharp fluctuations in inflations can serve to destabilize the financial system, in case of increasing the cost of debt if inflation falls suddenly. Financial stability and monetary stability are see4n to be complementary to each other. However, it not to conclude that economic and monetary stability are mutually exclusive (Fisher, pp, 187-211). The price bubbles and other diagnoses of financial volatility are the predictors of financial and economic crises. The primary load is on the prices of assets. The existence of asset price bubbles contradicts the efficient markets hypothesis thereby implying a violation of origin of the hypotheses. It includes rational optimization by individuals and the efficiency of competitive markets. The new classical view assumes that markets reach equilibrium and clear continuously. There may be cases of temporal equilibrium that arise due to exogenous shock. However, flexible markets are assumed to re-equilibrate. It means that price movements will be by the arrival of new information. There is a reasonable theoretical basis to claim that asset price bubbles emerge as a result of relatively modest deviations from the joint hypothesis of investor rationality and market efficiency. There is strong evidence for the absence of bubbles. Therefore, it can be argued that a bubble is a result of a random sequence of constant upward movement in prices relative to underlying fundamental value (Matsuyama, pp, 1-60). Conclusion Credit market imperfections provide an understanding of the various critical issues in business cycles, growth and development and also in international economics. Economists have left a wide range of models that give conflicting results. Various implications of the imperfections of the credit markets are in the essay. An analysis of how imperfections in credit markets interact with asset price volatility in the Determination of macroeconomic outcomes is. References Bernanke, Ben and Mark Gertler, Inside the Black Box: The Credit Channel of Monetary Policy Transmission. Journal of Economic Perspectives 9, (Fall 1995): pp. 27-48. Bernanke, Ben and Mark Gertler, Monetary policy and Asset Price Volatility Economic Review (Fourth Quarter, 1999) pp. 17-51. Federal Reserve Bank of Kansas City Economic Perspectives 24 (Fall 2010) pp. 21- 44. Filardo, Andrew J., Monetary policy and Asset Price Volatility Economic Review (Third Quarter, 2000) pp. 11-37. Federal Reserve Bank of Kansas City Fisher, Jonas DM. "Credit market imperfections and the heterogeneous response of firms to monetary shocks." Journal of Money, Credit, and Banking (1999): 187-211. Gertler, Mark, and Simon Gilchrist. "The role of credit market imperfections in the monetary transmission mechanism: arguments and evidence." The Scandinavian. Journal of Economics (1993): 43-64. Matsuyama, Kiminori. "Aggregate implications of credit market imperfections." NBER Macroeconomics Annual 2007, Volume 22. University of Chicago Press, 2008. 1-60. Woodford, Michael, Financial Intermediation and Macroeconomic Analysis. The Journal of Read More