Financial Crises Overview Flashcards
(16 cards)
What is a financial crisis?
A financial crisis occurs when financial assets suddenly lose a large part of their nominal value. It is typically characterized by sharp declines in asset prices, the failure of financial institutions, and disruption in the normal flow of credit.
What is the underlying problem of financial crises?
Financial crises are fundamentally linked to asymmetric information between borrowers and potential investors.
What are the two forms of information imbalance in financial crises?
The two forms are adverse selection, occurring before the agreement, and moral hazard, occurring after financing is secured.
What are the distinct stages of financial crises in advanced economies?
The stages are: Stage One: Initial Phase, Stage Two: Banking Crisis, Stage Three: Debt Deflation.
What triggers the Initial Phase of a financial crisis?
It can be triggered by factors such as credit boom and bust, asset-price boom and bust, and an increase in uncertainty.
What is a credit boom?
It’s a period when lending in economy grows faster than the economy itself
Households and businesses and govs borrow more money due to low interest rates and lending being easier
It increases consumption and rises the value of assets in the short term
In the long term too much borrowing will have prices crash, borrowers take more debt than they can repay, leading to a recession
What happens during the Banking Crisis stage?
Deteriorating balance sheets drive financial institutions toward insolvency, potentially triggering bank panics.
They suffer losses on loans, loss of confidence causing hasty withdrawals, insufficient liquidity to meet those withdrawals
What is debt deflation?
Debt deflation occurs when asset prices fall but debt levels do not adjust, increasing the debt burden
What is an example of debt deflation?
If a firm has assets of $100 million and liabilities of $90 million, a 10% price level fall reduces its net worth to $1 million.
Example: Assets = $100M, Liabilities = $90M, Net Worth = $10M; Price fall = 10%.
What historical event is considered the worst financial crisis in the US?
The Great Depression is considered the worst financial crisis ever in the US.
US prices fell but borrowers had to repay loans at their original nominal value
What initiated the Great Depression?
It began with a substantial appreciation of stock prices in 1928 and 1929, described as excessive speculation.
What was the Federal Reserve’s response to the stock market boom before the Great Depression?
The Federal Reserve implemented a tight monetary policy, increasing interest rates.
It slows economic activity, hurting businesses and borrowers
What exacerbated the banking crisis during the Great Depression?
Severe droughts in the Midwest led to a sharp decline in agricultural production, causing widespread bank failures.
What was the impact of increased asymmetric information during the Great Depression?
Adverse selection and moral hazard became severe, restricting firms’ access to financing.
What was the unemployment rate during the Great Depression?
The unemployment rate reached around 25% during the prolonged financial crisis.
What was the global impact of the US financial crisis during the Great Depression?
The contraction of the US economy led to decreased demand for foreign goods, resulting in a worldwide depression.
