The purpose of monetary policies is to allow the government to have a means of controlling the local economy. The policy achieves its duties by controlling the supplies of money into the economy (Airaudo et al., 2015). The process is controlled through three main activities that have both direct and indirect effects on assets. The first tool is open-market operations; through government securities buying and selling, the Federal Reserve System (Fed) affects money supply and interest rates (Airaudo et al., 2015). Increasing the supply of currency through the selling of government bonds increases cash reserves that stabilize the market, thereby allowing for easier credit lending from banks. The second tool is the utilization of discount rates, which directly affects the interest rates of loans imposed by banks.
An increased discount rate has the direct effect of reducing the lending amount. The results on fixed assets would be limited investments, thereby directly affecting its depreciation value (Airaudo et al., 2015). Finally, the third tool is the modification in bank reserve requirements. The Feds require each bank to have a specific percentage of deposits and reserves with the Federal Reserve System (Airaudo et al., 2015). By controlling the reserve requirements, the Feds can increase or decrease the reserve-ration directly affecting commercial banks' lending operations. By influencing the availability of money in the economy, it directly affects the value of asset prices.
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However, when the notion of asset price stabilizing is addressed from the perspective of house prices, the stabilizing process takes place using the balance sheet channels. The balance sheet channels have two theories with similar outcomes; however, through different processes. The first mechanism is through traditional economic theories; they support the notion that interest rates have a significant impact on the economy by affecting the investment and spending decisions. In other words, increasing interest rates increases currency cost, which results in reduced spending and investments. Therefore, from the tractional theory’s perspective, stabilizing asset prices involves affecting the demand for credit.
The new theories used in the balance sheet channels propose similar relations between interest rates, investments, and spending decisions. However, the new theories' approach impacts the balance sheets of financial institutions, individuals, and businesses. By increasing the interest rates, the outcome is negative as the previously listed parties' balance sheets decrease. The result is a reduction in the value of bonds, stocks, and real estate. Decreasing interest rates, on the other hand, promotes an increase in value. The latter action also strengthens banks and other financial firms to extend credit, thereby impacting its supply.
However, based on the notion of asset bubbles and baking crises, it is evident that it is practically impossible to stabilize asset prices, given the market's volatile nature. Any attempt to deflate or influence asset prices has the potential of “pricking the bubble.” The results of the action can be summarized with the effects of the 2008/2009 financial crisis. Numerous financial organizations, such as banks, were unable to endure the free-fall of the economy. The effects were adverse and impacted the global economy. Additionally, it is impossible to predict asset bubbles; rather, they are identified after they have burst, and the economy is deteriorating.
Therefore, based on the argument that the asset prices are influenced by traditional and new theories of balance sheet channels, market asset prices are dynamically influenced by numerous external factors. The previously mentioned financial crisis is a demonstration of the volatile nature of modern economic markets. The real estate asset bubble burst due to property being too expensive for typical investors to purchase. The sudden reduction in demand resulted in the prices of property reducing rapidly. The rapid reduction resulted in a cascading effect that resulted in other market sectors being affected. Hence, the real estate bubble had burst due to the unduly high risks involved in the housing system. With more investments already placed on housing, the sudden decrease in demand, coupled with an increase in supply, resulted in stopping currency flow into the sector. Nevertheless, it is not possible to stabilize asset prices using monetary policies.
Reference
Airaudo, M., Nistico, S., & Zanna, L. (2015). Learning, Monetary Policy, and Asset Prices. Journal Of Money, Credit And Banking , 47 (7), 1273-1307. https://doi.org/10.1111/jmcb.12245
