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Chapter 9

Chapter 9 EC223.docx

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Angela Trimarchi

EC223 Chapter 9 – Financial Crises and the Subprime Meltdown Week 8 Factors Causing Financial Crises -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 Asset Market Effects on Balance Sheets Stock Market Decline -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 Price Level -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 -An unanticipated decline in the aggregate price level thus leads to a drop in lending and economic activity Unanticipated Decline in the Value of the Domestic Currency -Many nonfinancial firms, banks, and governments in developing countries find it easier to issue debt denominated in foreign currencies rather than in their own currency Asset Write-downs -Asset price declines also lead to write-downs of the value of the assets side o the balance sheets of financial institutions Deterioration in Financial Institutions’ Balance Sheets -The state of banks’ and other financial intermediaries’ balance sheets has an important effect on lending Banking Crises -If the deterioration in financial institutions’ balance sheets is severe enough, the institutions will start to fail – fear can spread from one institution to another, causing even healty ones to go under -A bank panic occurs when multiple banks fail simultaneously -The decrease in bank lending during a banking crisis decreases the supply of funds available to borrowers, which leads to higher interest rates Increases in Uncertainty -The inability of lenders to solve the adverse selection problem makes them less willing to lend, which leads to a decline in lending, investment, and aggregate economic activity EC223 Chapter 9 – Financial Crises and the Subprime Meltdown Week 8 Increases in Interest Rates -Increases in interest rates also play a role in promoting a financial crisis through their effect on cash flow, the difference between cash receipts and expenditures Government Fiscal Imbalances -In emerging-market countries, government fiscal imbalances may create fears of default on government debt Dynamics of Past Canadian Financial Crises -Financial crises in Canada have progressed in two and sometimes three stages Stage 1: Initiation of Financial Crisis Mismanagement of Financial Liberalization/Innovation -The seeds of a financial crisis are often sown when countries engage in financial liberalization, the elimination of restrictions on financial markets and institutions, or when major financial innovations are introduced to the marketplace Asset Price Boom and Bust -Asset-price bubbles are often also driven by credit booms, in which the large increase in credit is used to fund purchases of assets, thereby driving up their price -When the bubble bursts and asset prices realign with fundamental economic values, the resulting decline in net worth increases asymmetric information, making borrowers less credit-worthy and causing a contraction in lending and spending Spikes in Interest Rates -Higher interest rates lead to declines in cash flow for households and firms and a reduction in the number of good credit risks who are willing to borrow, both o which increase adverse selection and moral hazard, causing a decline in economic activity Increase in Uncertainty -Canadian financial rises have almost always started when uncertainty is high, either after a recession has begun or the stock market has crashed Stage 2: Banking Crisis -Because of the worsening business conditions and uncertainty about their banks’ health, depositors begin to withdraw their funds from banks and a banking crisis or bank panic often ensues -The resulting decline in the number of banks results in a loss of their information capita and worsening adverse selection and moral hazard problems in the credit markets, leading to a further spiralling down of the economy Stage 3: Debt Deflation -A substantial unanticipated decline in the price level sets in, leading to further deterioration in firms’ net worth because of the increased burden of indebtedness -With debt deflation, the adverse selection and moral hazard problem continue to increase so that lending, investment spending and aggregate economic activity remain depressed for a long time – Ex. EC223 Chapter 9 – Financial Crises and
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