(Topic 6) Financial Crises

Question 1

How does a financial crisis occur?

Answer 1

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

What is asymmetric information?

Answer 2

A barrier between savers and firms with productive investment opportunities.

Question 3

The dynamics of financial crises in advanced economies can be summarised into three key stages, what are they?

Answer 3

1. Initiation of the Financial Crisis
2. Banking Crisis
3. Debt Deflation

Question 4

What ways can financial crises begin?

Answer 4

• Credit booms and busts
• Asset price booms and busts
• Increase in uncertainty

Question 5

Crises can begin with a mismanagement of financial liberalisation or innovation. Leading financial institutions can carelessly lend creating a ________ _____.

Answer 5

Credit boom.

Question 6

Government safety nets weaken incentives for risk management, thus depositors ignore bank risk-taking. Loan losses then accrue, asset values fall then capital reduces. Financial institutions cut back in lending, what is this process called?

Answer 6

Deleveraging.

Question 7

Prices of assets such as shares and real estate can exceed their fundamental economic values. What is this term known as?

Answer 7

Irrational Exuberance.

Question 8

The rise of asset prices above their fundamental values is known as what?

Answer 8

An asset price-bubble.

This can often be driven by a credit boom.

Question 9

What happens when a price-bubble bursts?

Answer 9

Stock prices tumble and corporate net worth falls as well. Moral hazard increases as firms have little to lose. Institutions also see a fall in their assets, leading again to deleveraging and thus to a decline in economic activity.

Question 10

What is debt deflation?

Answer 10

Where asset prices fall, but debt levels do not adjust, increasing debt burden.

Question 11

How did the Fed try to curb the period of excessive speculation in 1929?

Answer 11

A tight monetary policy.

This lead to a stock market collapse of more than 20% in October 1929, and losing a further 20% by the end of 1929.

Question 12

What do some believe caused the Housing Price Bubble?

Answer 12

Low interest rates from 2003–06