Topic 6: Key Stuff

Question 1

What are the 4 mechanisms

Answer 1

Balance Sheet
Loanable Funds
Collateral Value
Leverage

Question 2

Balance sheet mechanism

Answer 2

Output drops → Borrowers’ wealth drops → Borrowers become less able to
attract external finance.

Borrower wealth drops proportionately more than output because of leverage → Credit/GDP drops.

Question 3

Leverage mechanism

Answer 3

Output drops → Uncertainty increases → Borrowers become less able to
issue debt

When uncertainty increases, leverage drops.

Question 4

Collateral value mechanism

Answer 4

Collateral values drop → Borrowers become less able to attract external
finance → Economic activity drops → Collateral values drop further.

Question 5

Loanable funds mechanism

Answer 5

Bank equity capital drops → Bank-dependent firms become less able to
borrow → Economic activity drops → Bank equity capital drops further.

Question 6

Overall Financial Accelerator Mechanism (firms and households)

Answer 6

Firms and households:
Economic activity drops → Debt burdens rise → Bankruptcies and less new
lending.
→ Foreclosures and sales of collateral → Collateral values drop → More
bankruptcies and less new lending.
→ Economic activity drops → Incomes drop → Debt burdens rise.

Question 7

Overall Financial Accelerator Mechanism (banks)

Answer 7

Banks:
Losses on loans that defaulted → Equity capital drops.
→ Concerns about solvency → Runs.
Concerns about solvency and runs → Less new lending (hold more cash).
Bank failures and less new lending → Economic activity drops → …