Chapter 9

Question 1

Financial crisis

Answer 1

occurs when there is a particularly large disruption to information flows in financial markets, with the result that financial frictions increase sharply and financial markets stop functioning

Question 2

Dynamics of financial crises

Answer 2

Stage One: Initiation of a Financial Crisis
-Credit Boom and Bust: Mismanagement of financial liberalization/innovation leading to asset price boom and bust, Asset-price Boom and Bust, Increase in Uncertainty
Stage two: Banking Crisis
Stage three: Debt Deflation

Question 3

Causes of the Great Depression

Answer 3

Stock market crash, bank panics, continuing decline in stock prices, debt deflation

Question 4

Causes of the 2007-2009 Financial Crisis

Answer 4

1) Financial innovations emerge in the mortgage markets
-Subprime mortgage, Mortgage-backed securities, Collateralized debt obligations (CDOs)
2) Housing price bubble forms
Increase in liquidity from cash flows surging to the United States, Development of subprime mortgage market fueled housing demand and housing prices
3) Agency problems arise
-“Originate-to-distribute” model is subject to principal-(investor) agent (mortgage broker) problem, Borrowers had little incentive to disclose information about their ability to pay, Commercial and investment banks (as well as rating agencies) had weak incentives to assess the quality of securities
4) Information problems surface
5) Housing price bubble bursts

Question 5

Collateralized Debt Obligations (CDO’s)

Answer 5

involves a corporate entity called a special purpose vehicle (SPV) that buys a collection of assets such as corporate bonds and loans, commercial real estate bonds, and mortgage-backed securities

Question 6

Effects of 2007-2009 Financial Crisis

Answer 6

• After a sustained boom, housing prices began a long decline beginning in 2006.
• The decline in housing prices contributed to a rise in defaults on mortgages and a deterioration in the balance sheet of financial institutions.
• This development in turn caused a run on the shadow banking system.

Question 7

Dynamics of financial crises in emerging market economics

Answer 7

Stage One: Initial Phase
-Path A: Credit boom and bust
-Path B: Severe fiscal imbalances
Stage Two: Currency Crises - triggered by deterioration of bank balance sheets and severe fiscal imbalances
Stage Three: Full-fledged financial crisis

Question 8

Ways to prevent emerging market financial crises

Answer 8

• Beef up prudential regulation and supervision of banks
• Encourage disclosure and market-based discipline
• Limit currency mismatch
• Sequence financial liberalization