1. Why do financial crises occur and why are they so damaging to the economy? 2.
ID: 2505688 • Letter: 1
Question
1. Why do financial crises occur and why are they so damaging to the economy?
2. Suppose the Bank of Canada announces that it will raise the money supply in the future but
does not change the money supply today. Using the Fisher equation, explain what happens to the nominal
interest rate.
3. Critically explain why interest rates are pro-cyclical, using the supply and demand for bonds
framework.
4. Briefly explain the dynamics of the 2007 financial crisis in terms of adverse selection and moral
hazard.
5. Explain, using the best framework you can think of (based on our class discussion), the effect
of a large federal deficit on interest rates.
Explanation / Answer
Answer - 1 Three stages of banking crises stage one initiation of financial crisis deterioration in financial institutions' balance sheets, ass4et price decline, increase in interest rates, increase in uncertainty all leads to adverse selection and moral hazard problems worsening stage two banking crisis economic activity declines, causing banking crisis, causing adverse selection and moral hazard problems to worsen, causing economic activity decline stage three debt deflation unanticipated decline in price level, causing adverse selection and moral hazard problems worsen, causing economic activity to decline As a result of this credit boom lending spree by financial institutions deleveraging cutting back on lending increase in interest rate caused by increase in demand for credit decrease in money supply increase in interest rate causes # bad credit risks to increase # good credit risks to decrease as interest rate increases and CF decrease banks must raise funds externally leads to increased adverse selection and moral hazard economic activity decreases bank panic multiple banks fail simultaneously debt deflation substantial unanticipated decline in price level sets in, leading to a further deterioration in firm's net worth because of the increased burden of indebtedness (because denominated in foreign currency) impact of financial crisis most evident in 5 key areas 1. US residential housing market 2. financial institution balance sheets 3. the shadow banking system 4. global financial markets 5. headline-grabbing failures of major firms in the financial industry shadow banking system non-depository financial firms such as hedge funds, investment banks etc.
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