7 - The Financial Sector And Crisis

Question 1

Should insolvent banks be rescued?

Answer 1

The economy depends on the continuous provision of core banking services.
MORAL HAZARD may arise if there are expectations that gov. will step in to bail a failing bank.
Policy makers should trade off this problem with the disruptive effects of bank failure.

Question 2

The three key characteristics of banking crises are:

Answer 2

1. Deep and prolonged asset price collapse.
2. Large and lasting adverse effects on output and unemployment.
3. Government debt explosion - primarily due to collapse in tax revenues, secondarily bank bailout.

Question 3

Financial cycle and inflation-targeting CBs setting monetary policy.

Answer 3

In the inflation-targeting monetary policy, financial variables are only considered to the extent that they influence forecast CPI inflation.

Question 4

A city with abundant space for expansion (housing)

Answer 4

A spike in demand for housing will see house prices rise in the short-run.
Supply is perfectly in elastic in the short-run: new houses cannot be built instantaneously.
An extended period of high demand for housing will be accommodated by a similar increase in supply.

Question 5

House price bubble

Answer 5

If one observed steeply rising house prices where these fundamentals were in place, it would be reasonable to infer that a bubble is underway.
-house prices must eventually fall to their fundamental levels
In this setting, ever increasing house prices are consistent with extrapolative expectations driving a bubble process.

Question 6

Loan-to-value ratio

Answer 6

The value of the loan received divided by the value of the property purchased.

Question 7

Asset price bubble

Answer 7

Occurs when the price of an asset far exceeds its economic fundamentals.
Eg housing
-rise in demand for mortgages, which pushes up house prices
-expectation that prices will rise further
-holding more houses is a ‘good’ strategy

Question 8

Financial accelerator

Answer 8

When the household’s net worth (difference between value of house and mortgage) increases, it is able to borrow more.
-credit constraint is relaxed

Question 9

Financial asset feedback process, which factors can contribute to a reduced perception of risk?

Answer 9

1. Reduction in macroeconomic volatility increasing the likelihood that households will be able to service their mortgages.
2. Rising house prices, which increase the value of housing collateral compared to mortgage loan values.
3. Financial innovation aimed at reducing credit risk.

Question 10

How does the perceived reduction in risk lead to Investment Banks (IBs) becoming more highly leveraged?

Answer 10

Buy as many financial assets as possible as long as they offer a positive expected return.
-restricted by size of their equity and ability to borrow from saver households
Savers are willing to lend more to IBs after a fall in risk, enabling IBs to borrow more and ‘lever up’ by expanding balance sheets.

Question 11

What is a balance sheet recession?

Answer 11

Those that follow the bursting of a large credit-fuelled asset price bubbles.
-collapse of asset prices on balance sheets of households and firms, bringing financial accelerator into play which amplifies downturn.

Question 12

Balance sheet recession: what happens?

Answer 12

Households and firms deleverage: reduce their debt so as to repair their balance sheets.

• increase savings which reduces aggregate demand and slows down recovery
• shifts IS curve left
• monetary policy is limited by the zero lower bound (deflation trap)