Econ 5200

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How can bursting of an asset-price bubble in the stock market help trigger a financial crisis?

* When this happens the price of the bubble will realign with their fundamental economic values, companies will see their net worth decline and the value of their collateral they can pledge will drop. It causes a decline in the value of the institutions’ asset, whereby causing a decline in the net worth of the company. This deterioration in the balance sheets causes them to deleverage, worsening the decline of economic activity.

How does the unanticipated decline in the price level cause a drop in lending?

* Because many debt contracts are fixed interest rates and typically have fairly long maturity—when an unanticipated decline in the price level happens, it will raise the real value of the borrowing firms’ liabilities, but it will not raise the real value of the borrowing firms’ assets. Thus, the borrowing firms’ net worth in real terms declines. When this happens there will be a sharp drop in the price level, increasing moral hazard and adverse selection, which will make a firms economic activity, (lending) decline. Also step 3 of 3 in the U.S. financial crisis.

How does deterioration in the balance sheets of financial institutions and the simultaneous failures of these institutions cause a decline in economic activity?

* With the deterioration of the balance sheets, institutions will begin to fail. With failures there will be less organizations to lend resources. When you have fewer resources to lend, investment spending goes down, which in turn causes economic activity to decrease.

How can financial liberalization lead to financial crises?

* It can lead to financial crises by lenders lending, or engaging in, risky lending practices. When an institution engages in these practices they suffer long-term losses, they have to cut back on lending.

“Financial engineering always leads to a more efficient financial system.” Is...
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