FINANCIAL INSTABILITY, CREDIT GROWTH AND OPTIMAL MONETARY POLICY DESIGN

Paper Number :WP29/2023
Publication Date :June 27, 2023

An increase in policy rates, in order to control inflation, may lead to a credit crunch, slowdown in economic growth and spurt in non-performing loans. In this paper, we explore the impact of policy rate shocks on the volume and cost of bank credit, in an imperfect competition framework. We examine the conditions under which credit growth may occur, despite a rise in policy rates. This phenomenon is consistent with recent Indian experience. The paper also analyzes central bank monetary policy announcements, in an extensive game-theoretic structure, which take into account future decisions by banks and borrowers, on the quantum and cost of credit. We discuss how the central bank fixes its optimal policy rates, given its dual objectives to manage price stability and financial stability in an economy. We highlight the dilemma that it faces when it tries to manage both inflation and systemic risk, through its policy rate announcements.