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Inflation in India - Wikipedia
D Phys. E Phys. Fluids Phys. Materials Phys. Applied Phys. Beams Phys. Robinson argued that financial sector development follows economic growth. The third view maintains a simultaneous causal relationship between financial development and economic growth. Patrick found that the causal relationship between the two was not static over the development process.
When economic growth occurs, the demand following response dominates the supply leading response. But this sequential process was not generic across the industries or the sectors. Empirical studies also support the three hypotheses. As an example, King and Levine showed a range of financial indicators robustly and positively correlated with economic growth. Demirguc-Kunt and Levine found a positive relationship between stock market, market microstructure and the development of financial institutions. Demetriades and Hussein found finance as a main factor in the process of economic development.
Odedokun showed that financial intermediation supported economic growth in most of the developing countries.
Liu et. They found that high investment rate accelerated economic growth in Japan, while it did not lead to better growth performance in Taiwan and Korea, reflecting upon allocation efficiency in the two countries. Ang in a study of Malaysia showed that financial development led to higher output growth by promoting both private saving and private investment. Odhiambo studied the dynamic causal relationship between financial depth and economic growth in Kenya and found a distinct unidirectional causal relationship between economic growth to financial development.
The study also concluded that any argument in which financial development unambiguously leads to economic growth should be treated with extreme caution. Until Kindleberger , most studies on the role of the financial sector in economic progress emphasized the degree of financial development, usually, measured in terms of the size, depth, openness and competitiveness of financial institutions. The stability and efficiency of institutions did not receive much attention, possible due to the intuition that the competitiveness and growth of financial institutions is due to their efficiency in operations and resource allocation and optimal risk management.
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Kindleberger and later Minsky put forward a viewpoint about financial instability that indicated a negative influence of financial sector on economic growth. Kindleberger argued that the loss of confidence and trust in institutions could fuel disintermediation and institutional closures, and when confidence falls, investment probably falls too.
According to Ang , institutional instability can also affect the organization of the financial sector and, consequently, increase the cost of transactions and causes the problems within the payments system. These transaction costs, which are real resources leads to misallocation of the resources and hence the rate of economic growth may suffer.
Thus, a sound financial system instils confidence among savers and investors so that resources can be effectively mobilized to increase productivity in the economy. Such an overleveraged situation provides congenial conditions for a crisis caused by firms default events on their loan repayments due to higher financial costs. Consequently, higher financial costs and lower income can both lead to higher delinquency rates and hence the economic recession. Taking inspiration from Kindleberger and Minsky , Eichengreen and Arteta studied 75 emerging market economies for the period — They showed that rapid domestic credit growth was one of the key determinants of emerging market banking crises.
Similarly, Borio and Lowe using annual data for 34 countries from to showed that sustained and rapid credit growth, combined with large increases in asset prices, increased the probability of financial instability.
Calderon et. These policies reduced business cycles and economic fluctuations which led to more predictability power. This predictive confidence provided a better investment environment that resulted in more rapid growth. The linkage of a financial system and its stability with inflation conditions and monetary policy has been a very contentious issue in the literature. Deliberation in this context entails two crucial issues: the causal relationship between inflation and financial stability and whether financial stability should be pursued as a goal of policy, especially by inflation targeting central banks.
Studies provide alternative perspectives about the channels through which financial stability and inflation can share a causal relationship Bordo, , Bordo et. First, as derived from Fisher and and Schwartz , , there is a common perspective that inflation conditions can interfere with the ability of the financial sector to allocate resources effectively Bordo et.
This is because inflation increases uncertainties about future return possibilities.
Bernanke and Gertler and Bernanke, et. An upward growth trajectory accompanied by high inflation could cause over-investment and asset price bubbles.
Inflation Targeting and Financial Stability: A Perspective from the Developing World
Sometimes, the foundation for financial instability emanates from excessive credit growth resulted due to realistic return expectations and not for real investment Boyd, Levine and Smith, ;Huybens and Smith, , According to Cukierman banks cannot pass the policy interest rate, an inflationary control measure of the central banks, as quickly to their assets as to their liabilities which lead to increasing the interest rate mismatch and, thus, market risk and financial instability. Second, some studies emphasize that informational frictions necessarily play a substantial role only when inflation exceeds certain critical or threshold level Azariadas and Smith, , Boyd and Smith, ; Choi, et.
According to these studies, credit market frictions may be nonbinding under low inflation environment. Therefore, low inflation may not distort the flow of information or interfere with resource allocation and growth. However, beyond the threshold level of inflation, credit market frictions become binding and credit rationing intensifies and financial sector performance deteriorates.
When inflation exceeds a threshold, perfect foresight dynamics do not allow an economy to converge to a steady state displaying either an active financial system or a high level of real activity.
Inflation Targeting and Financial Stability
According to Borio , financial imbalances can develop in a low inflation environment owing to favourable supply side developments, productivity gains, globalization and technological advances. In this context, the credibility of price stability by anchoring inflationary expectations induces greater stickiness in wages, can delay the inflationary pressures in the short term but this may lead to unsustainable expansion of aggregate demand in long run.
The low inflation obviates the need of tighten monetary policy and lead to the development of the imbalances. The literature on the relationship of financial stability with monetary policy and price stability is divided as to whether there are synergies or a trade-off between them. Schwartz states that price stability lead to low risk of interest rate mismatches and low inflation risk premium. These minimisation of risks resulted from the accurate prediction of the interest rate due to credibly maintained prices. The proper risk pricing contribute to financial soundness.
From this perspective, price stability can serve as both necessary and sufficient conditions for financial stability. Some authors, however, take a cautious stance in this regard and argue that price stability can be necessary but not a sufficient condition for achieving financial stability Issing, ; Padoa-Schioppa, Mishkin has argued that a high interest rate measure to control inflation, could negatively affect the balance sheets of both banks and firms.
Herrero et. Positive inflation surprises can redistribute real wealth from lenders to borrowers and negative inflation surprises can have the opposite effect. A very tight monetary policy may lead to disintermediation and hence the financial instability.
It is argued that a very low inflation levels resulted from very tight monetary policy may lead to very low interest rates that would make cash holdings more attractive than interestbearing bank deposits and hence the disintermediation. Further, a sharp increase in real interest rates have adverse effects on the balance sheets of banks and may lead to credit crunch, with adverse consequences for the financial and real sectors.
Driffill et. Thus smoothing may be both unnecessary and undesirable. Granville et. They suggested that the interest rate instrument used for inflation targeting is conducive to financial stability. Dovern et. Banking sectors stress was captured alternatively through return on equity and loan writeoffs. The authors found that the level of stress in the banking sector is strongly affected by monetary policy shocks. Rotondi et. Goodfriend , Smith and Egteren argued that an aggressive monetary policy induced macroeconomic stability might lead to riskier behaviour of commercial banks and other financial institutions due to anticipated implicit guarantees.
It is challenging task for central banks to maintain monetary and financial stability simultaneously. The monetary stability in terms of low inflation could confound the imbalances that could lead to higher asset price volatility which is having serious macroeconomic consequences Borio et. Poloz argued that successful inflation targeting might lead to financial volatility and hence the central banks might better focus on making financial systems more resilient than on trying to develop more sophisticated policies aimed at reducing financial volatility.
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Kishan and Opiela argued that small and poorly capitalized banks exhibit a significantly stronger loan contraction to monetary shocks compared to large and well-capitalized banks. Kashyap and Stein , , pointed out the asymmetric effects of monetary transmission under bank lending channel across banks size, capitalization and liquidity. De Graeve, et. The distress responses have differential impact across the size, capitalization and ownership of the banks.
This finding supports the regulators to think about extending the banking regulations beyond the capital requirement. The nexus among price stability, financial stability and monetary transmission highlights the crucial need for close coordination between monetary and regulatory authority.
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Slovik and Cournede studied the medium-term impact of Basel III requirements on aggregate economic costs for the same economies by combining an accountingbased framework and found an increase in lending spreads by 0. Angelini et. Gambacorta , using a vector error correction model VECM , showed that higher capital and liquidity requirements could lead to limited negative effects on long-run output and banks earnings.
The cost-benefit analysis performed by Locarno , attempted for a long run and short run assessment for the Italian economy with an exclusive consideration of capital and liquidity requirements. Overall, the economic impact of the new regulation is small. Eichberger and Summer showed that the immediate impact of a capital adequacy constraint of a bank could lead to decrease of loans to firms and increase in its interbank position. Banks take higher risk in their lending activity by granting loans with higher default probability and loss given default credit risk , but also by lengthening the loan maturity as in Diamond and Rajan , i.
Wong et. Taking a similar cost-benefit approach, Yun et. In the similar approach Caggiano and Calice assessed the impact of higher regulatory capital requirements on aggregate output in a panel data model framework for African economies and found net benefits of higher regulatory capital requirements in terms of the resilient banking systems.