EC223 Chapter Notes - Chapter 9: Speculative Attack, Mortgage Insurance, Debt Deflation
Document Summary
Six categories play an important role in financial crises: asset market effects on balance sheets, deterioration in financial institutions" balance sheets, banking crises, increases in uncertainty, increases in interest rates, and government fiscal imbalances. A sharp decline in the stock market is one factor that can cause a serious deterioration in borrowing firms" balance sheets. This deterioration can increase adverse selection and moral hazard problems in financial markets and provoke a financial crisis. The decline in corporate net worth as a result of a stock market decline increases moral hazard by providing incentives for borrowing firms to make risky investments, as they now have less to lose if their investments go sour. Unanticipated decline in the price level raises the value of borrowing firms" liabilities in real terms. A sharp drop in the price level causes a substantial decline in real net worth for borrowing firms and an increase in adverse selection and moral hazard problems facing lenders.
