chp12

Question 1

what are financial frictions?

Answer 1

when there’s a disruption to efficient capital allocations

Question 2

what type of information is involved with financial frictions?

Answer 2

assymetric information

Question 3

assymetric information

Answer 3

adverse selection and moral hazard

Question 4

why is it unclear if loans will be paid back?

Answer 4

banks don’t know if they are loaning money to a high or low risk person

Question 5

what do banks do if they can’t decide whether a person is high or low risk to give a loan to?

Answer 5

not loan out any funds at all

Question 6

if banks don’t give out loans (because they’re being cautious) what will happen?

Answer 6

inefficient number of loans being made, affecting general levels of
consumption for items such as houses and cars. This is an example of a financial friction.

Question 7

banks don’t give out loans to be cautious. Less loans mean consumption of things are affected. what is this an example of?

Answer 7

financial friction

Question 8

financial crisis

Answer 8

when economic activity suffers from an information problem

Question 9

what does a financial crisis cause?

Answer 9

tremendous financial frictions

Question 10

name the 3 stages involved in a financial crisis (IBD)

Answer 10

initial phase
banking crisis
debt inflation

Question 11

What do we observe in the initial phase of a financial crisis? (Mr. A)

Answer 11

more uncertainty
reduction in the balance sheets of banks
asset-price decline.

Question 12

what is a result of the initial phase of a financial crisis?

Answer 12

causes asymmetric information

leads to banking stage 2: crisis

Question 13

what do we observe in the banking crisis stage of a financial crisis (W GF)

Answer 13

worsened asymmetric information.
general fall in economic activity (output or consumption)
fallout amongst banking institutions

Question 14

What is a result of the banking crisis stage of a financial crisis?

Answer 14

leads to 3rd stage: debt inflation

Question 15

what do we observe in the debt inflation stage of a financial crisis?

Answer 15

unexpected decline (negative shock) in price level (think about the opposite of inflation).

Question 16

what is a result of the debt inflation stage of a financial crisis?

Answer 16

even worse asymmetric information and falls to economic activity occur.

Question 17

what can we find from monetary policy for a financial crisis?

Answer 17

the Federal Reserve attempt to counteract the effects of financial crisis to reach a “steady-state” again.

Question 18

what does the Federal Reserve try to do during a financial crisis?

Answer 18

counteract effects to reach a “steady- state”

Question 19

(initial phase) define financial innovation

Answer 19

creating new forms of loans and financial products in an economy

Question 20

(initial phase) define financial liberalisation

Answer 20

reducing and removing restrictions on banking institutions

Question 21

explain financial innovation

Answer 21

banks offer loans with a new alternative collateral such as Calvin Klein hoodies. Josh now may be able to take out loans
by using hoodies as a guarantee for the loan in case of default.

Question 22

explain financial liberalisation

Answer 22

If before a bank was only allowed to lend 80% of its total funds and now can instead lend up to 100%, then this reflects a change in the required reserves requirement. This gives
greater flexibility to banks to issue loans. This is a form of financial liberalization.

Question 23

what is credit boom a possible side-effect of?

Answer 23

financial liberalisation

Question 24

(initial phase) define credit boom

Answer 24

possible side-effect of financial liberalization in which banks choose to make many loans in comparison to a period before the removal of restrictions

Question 25

(initial phase) define deleveraging

Answer 25

a condition by which banks reduce the number of loans made to individuals or the amount of loans

Question 26

(initial phase) define asset price bubble

Answer 26

an asset’s price exceeds that of its fundamental value

Question 27

what does deleveraging tend to follow?

Answer 27

a credit boom, as banks have lent out most of its funds or capital

Question 28

why is it hard to say if asset price bubble actually exist or not?

Answer 28

only easy to see them after a decline happens or there's a crash in value

Question 29

give an exmaple of asset-price bubble

Answer 29

people paying £4mil for a home that has a fundamental value of £3mil

Question 30

(banking crisis and debt inflation) define fire sale

Answer 30

bank chooses to quickly sell its assets in order to increase its funds or capital

Question 31

(banking crisis and debt inflation) define debt inflation

Answer 31

price-level decreases (the opposite of inflation) leads to a decline in the value or net worth of firms

Question 32

example of debt inflation

Answer 32

If the products a firm sells are suddenly priced or valued at a lesser amount, then the overall worth of the firm decreases. For example, if General Motors produces cars that previously retailed for $20,000 and deflation leads to their retailing at $18,000, then it may be the case that General Motors suddenly declines in worth as a firm.

Question 33

(banking crisis and debt inflation) define haircut

Answer 33

situation where required collateral exceeds the amount of a loan

Question 34

example of a haircut situation

Answer 34

Josh has a 2-door convertible sports car (worth $45,000) and just decided to buy a second car (priced at $30,000) for day-to-day use. When Josh goes to the local bank to take out a loan for the car, the bank requires that Alan use the full worth of the sports car as collateral to take out a loan to buy the second car. The bank is exercising a haircut because the value of the collateral sports car exceeds that of the new car.

Question 35

(banking crisis and debt inflation) define financial derivative

Answer 35

a financial instrument which is tied in payoff to a previously issued security

Question 36

(banking crisis and debt inflation) what is Troubled Asset Relief Program (TRAP)

Answer 36

federal government enabled the U.S. Treasury to purchase subprime mortgage assets from struggling banking institutions

Question 37

what was TRAP made in response to?

Answer 37

07/08 financial crisis

Question 38

(banking crisis and debt inflation) define stress test

Answer 38

a test performed on a financial institution or bank to inspect potential losses and necessary capital to survive in periods of financial friction or crisis

Question 39

why are stress tests implemented? what do they reduce?

Answer 39

stop potentially problematic activity of banks in issuing loans.

Question 40

describe example of a stress test (what is a bank doing, what will the stress test check)

Answer 40

if a bank is loaning too much or is making loans to individuals with certain credit ratings, a stress test will check to see if the bank could continue to operate if suddenly a crisis occurred.

Question 41

what's the ultimate goal of the stress test

Answer 41

to help banks to recognise when they are acting haphazardly and curb this behaviour