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Chapter 18 Finanacial Crisis

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Louisiana State University
ECON 2035

Chapter 18 Financial Crisis 181 The Mechanics of Financial CrisesFinancial Crisis major disruption of the financial system typically involving crashes in asset prices and failures of financial institutions Center of most financial crises are crashes in asset prices failures of financial institutions or both Assetprice crashes are sudden large drops in the price of assets Financial institutions can fail either when they become insolvent or have a liquidity crisis oInsolvency occurs when the value of an institutions assets falls below the value of its liabilities Dangers of insolvencies are that they can spread from one financial firm to another Financial firms have debts to each other oIf one firm becomes insolvent then the value of assets in another firm will decrease possibly causing the firm to become insolvent and so onoNow negative net worth bank must be closed immediately oFinancial firms can also have a liquidity crisis because it lacks liquid funds to pay off scheduled payments on its deptMost assets are liquid and take time to be sold fire saleCould lead to insolvency An institution may not be able to sell these assets intime Like insolvencies liquidity crises can spread from one firm to another The direct costs of a financial crisis include losses to assets holders from lower asset prices and financial firm failures Greatest danger from a financial crisis arises indirectlythe potential of a crisis to adversely affect the economy Asset price crashes and financial failures can both reduce lending and spending oAsset price crashes reduce wealth DECREASE AE and the value of collateral DECREASE lendingOUTPUT DECREASEoBank failure cause less banks and become more cautious DECREASE lendingalso DECRESAE investment DECREASE AE leading to shortrun DECREASE firm earningsDECREASE demand for real estate and other durables INCREASE default
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