Connecting monetary policy with home loans

July 14th, 2007

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In this news media article, Home loans on tap: no deposit, no inspection, it said that:

THE mortgage stress crisis is being worsened by the boom in easy credit, with lenders approving loans without inspecting properties, offering large amounts to borrowers who have no deposit and encouraging buyers to take on debts that would eat up half their income.

How effect does monetary policy has on the average person on the street? Today, we will talk about that.

In our last article, What makes monetary policy ?loose? or ?tight??, we said that:

…the central bank cannot control the demand for money and credit. It can supply whatever amount of them that it wants, but it cannot force business and people to desire them. Put it simply, you can lead a horse to the water, but you cannot force it to drink.

Therefore, when setting an interest rate, the central bank supplies (or withdraw) whatever amount of money to (from) the financial system at a given quantity demanded for money. Therefore, money supply can only expand as far as the willingness of the central bank to supply additional money, and the economy is willing and able to take in more money in the form of debt and credit.

What is the demand for money?

For today’s article, we will look at one example of a demand for money?demand for home loans. Home loans are basically debt for the borrower and credit for the lender. They form part of the aggregate demand for money in the economy. In the above-mentioned news article, lenders are getting complacent in their credit standards. If the quantity of money (credit) is fixed in the economy, then any increase of demand will have to result in higher interest rates (price/cost of money). The fact that interest rates had not risen means that the quantity of money (credit) had to increase to accommodate its increased demand. If you look at the Australia’s M3 money supply (see Financial Aggregates – May 2007), you can see that money supply has been increasing steadily.

What does this mean?

In the case of home loans, the increase of easy credit offered to borrowers can have the effect of further inflating the prices of homes. But borrowers can never take on more debt indefinitely. It will come to the point when the debt-servicing burden of the economy will exceed its capacity and energy to repay. By then, the risk of debt defaults will increase, which can result in asset price deflation (see What can tip Australia into a downward property price spiral? and Spectre of deflation).

At this point, it looks to us that Australian borrowers may be at their limits of debt burdens. Therefore, any further increase in easy credit means that the risk of deflation led by debt defaults has to increase.