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In this article we will discuss about the credit availability doctrine with its criticisms.
The credit availability doctrine is associated with R. V. Roosa, a former official of both the Federal Reserve System and the US Treasury who in 1951 emphasised on the effect of a tight monetary policy on lenders rather than on borrowers in the money market. This is also called the Roosa Effect.
The availability thesis was put forward by Roosa primarily against two policies:
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(i) That investment demand is interest-inelastic; and
(ii) that tight monetary policy works only by raising the interest rate.
The availability doctrine explains how tight monetary policy achieves its objectives even though investors are unresponsive to increases in interest rates. This is possible when tight monetary policy induces lenders (i.e. banks) to cut back the availability of credit to borrowers. Thus the Roosa effect operates not on the demand for credit but on its supply so that monetary policy affects lenders rather than borrowers. The level of interest rates is assumed to govern the credit availability. There are two main components of the credit availability doctrine: non-price credit rationing and lock-in effect.
(1) Credit Rationing:
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It is argued that banks prefer to keep interest rates relatively at low levels during tight monetary policy, and ration the amount of lending to certain customers via non-price devices. When the central bank follows a tight monetary policy, the resources of commercial banks are cut which reduce their lending capacity. But banks in effect ration credit so that the level of interest rates does not rise to a market- clearing level.
They generally charge a standard interest rate from private borrowers. They deny credit to prospective borrowers who are willing to pay the going market interest rate. The decision to lend by banks depends not only on the interest rate but also on the status, creditworthiness and wealth of the borrowers or favouritism to old, valued customers.
What leads banks to embark upon credit rationing? When the central bank sells government securities in the open market, it increases their supply on the open market which lowers their price. These changes affect the banks in two ways:
First, they introduce uncertainties and expectations into the money market as a result of increases in bond yields.
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Second, the increase in yields of government securities make banks unwilling to sell government securities in order to obtain funds for advancing loans. That is why they resort to credit rationing.
(2) Lock-in Effect:
There is another reason for the unwillingness of banks to sell government securities which is called the “lock-in effect”. When the central bank sells government securities to implement its tight monetary policy, it increases their supply on the market. This lowers their price in the bank portfolios.
It means that banks which want to obtain funds for advancing loans by selling government securities do so at a capital loss. Since banks would be reluctant to realise capital losses, they would be “locked-in” to some of their holdings of government securities by their portfolio balancing behaviour.
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In other words, capital losses on the sale of government securities to the public to get more funds for advancing loans, make banks unwilling to sell government securities. Thus under the locking-in effect banks keep government securities in their asset portfolios which leads them to credit rationing and prevents them from advancing business loans.
The credit availability thesis is explained in Fig. 7. Suppose the economy is in equilibrium at point E where the supply curve of loanable funds S intersects the demand curve for loanable funds D. At this point, OL loans are supplied and demanded at the OR interest rate. When the money supply is increased by the Central bank through the open market purchase of securities, the supply curve shifts leftwards to S1.
But the banks are reluctant to raise the interest rate to their depositors and resort to non-price credit rationing. If they charge the same interest rate OR, they will ration L2L credit. If they charge the higher interest rate OR5 the amount of credit made available would still decline to OL1 from OL.
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So far as the lock-in effect is concerned, it is equal to the distance E2E at the interest rate OR. It shows unfilled demand for loanable funds equal to L2L when banks keep government securities in their portfolios in order to avoid capital losses.
Criticisms of Credit Availability Doctrine:
The credit availability doctrine has been criticised both on theoretical and empirical grounds:
1. It is based on the existence of different imperfections in the money market. So it is not possible to generalize the Behaviour of banks with regard to the holding of government securities and advancing of loans.
2. It is also assumed that when the central bank follows a tight monetary policy through open market sale of securities, it introduces uncertainties in the money market and in bank behaviour. But there is no clear evidence regarding market structure and bank behaviour.
3. This doctrine expects a bank to adjust its lending rate to changes in the market interest rate, but this adjustment involves time lag about which it is silent. In none of the versions of the credit availability, the time lag has not been precisely measured.
4. The credit availability thesis is incomplete because it includes only commercial banks and leaves out other financial intermediaries from the analysis.
5. So far as the “locking-in effect” is concerned, economists doubt its effectiveness because data on the behaviour of banks in the US during tight money periods in the 1960s and 1970s do not prove its operation.
Conclusion:
Despite these criticisms, the non-price credit rationing argument has been formalized and shown to be empirically relevant. This doctrine has thus popularized the view that tight monetary policy wields its effect through the availability of credit. To conclude with Prof. Johnson, “The availability doctrine has left its mark on the field, in as much as the majority of monetary economists would probably explain how monetary policy influences the economy by reference to its effects on the availability of and cost of credit, with the stress on availability.”
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