That's not how the market works. Let me repeat- if people can only borrow £200k at 5% then they can only afford a £200k house. It's that simple. What makes you so sure that 'it can't devalue'?
People will indeed sit tight. Doesn't matter. Markets are set at the margins- probate sellers, divorcing couples etc. People in negative equity will only be bankrupted if interest rates rise and remain so high as to be unnafordable.
The land supply is indeed finite, but it's nowhere near as finite as somewhere like Singapore. Hence my comment about planning laws. Same with 'affordable' houses. It's all down to government policy.
I bet the people sitting tight will sit tight longer than the banks offering smaller mortgages will when there bottom line is hit.
Besides why would banks limit the mortgages. They will do everything in there power to make them bigger as it's more profit.
In your version I think it would be more likely that to find the extra money plot sizes would shrink rather than land devalue. We would all end up in apartments or 3 story townhouses that would make a victorian terrace look like a mansion.
Their is to much money tied up in land for anyone important to let it devalue.