Anatomy of a financial crisis

Topics: Economics, Inflation, Federal Reserve System Pages: 2 (588 words) Published: October 13, 2013
In this article, Anatomy of a financial crisis, Frederic S. Mishkin provides explanations for understanding the nature of financial crises. Furthermore, Mishkin goes to explain past views of financial crises, the nature of asymmetric information in financial markets, the five primary factors that can substantially worsen a financial crisis, Debt-Deflation, historical evidence for common factors of financial crisis, monetary policymaking, and how each of these work together to create a financial crisis, respectively. Previous views on financial crises point towards two camps of thought, Monetarists and Non-Monetarists. Monetarists believe that banking panics are the root of financial crisis, because money supply is believed to be a major source of contraction in the aggregate economic activity in the United States. Non-Monetarists take a broader approach, including key factors such as: Asset price, failure of financial and nonfinancial firms, deflation or disinflation, disruption in for markets, or combinations. Unfortunately, these do not provide enough information to justify the inner-workings of a financial crisis individually. Government intervention isn’t always the answer for economic downturn, especially since it lowers the market efficiency. Transactions in the financial markets are subject to asymmetric information. Two problems are spawned from asymmetric information: Adverse Selection and Moral Hazard (before and after the transaction, respectively). Due to adverse selection, many positive projects that are beneficial—containing a positive NPV—are not undertaken. Investors are unsure of what is truly a high-quality investment. With moral hazard, the borrower has an increased incentive to take riskier actions in order to realize gains excess of original expectations; the lender bears the loss if the project doesn’t end up being fruitful. Understanding this, a financial crisis (according to Mishkin) can be defined as “…a disruption to financial...
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