Financial crisis - ECON 104Financial Crisis 1 What is the nature of the current crisis There are 3 big proximate causes a bunch of new and

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ECON 104---Financial Crisis 1. What is the nature of the current crisis?  There are 3 big proximate causes: a bunch of new  and unregulated assets emerged, and people traded them without knowing their value; there  was a bubble in asset prices, but now it is popping---asset prices (such as house prices)  have fallen, so that people feel poorer and don't want to spend;  credit markets have  tightened so that banks are less willing to lend and charge higher interest rates, pushing  down investment by people and firms;  2. Recall that if the conditions of the First Fundamental Theorem hold, credit markets defined  as the markets for borrowing and saving money, will be efficient.   2.1. This means, roughly, that good investments will be made and bad investments will not  be made because people will be able to borrow money to fund investments that pay off  in the long run.  2.2. However, if the conditions don't hold, some good investments may not get made, and  some bad investments may get made.   2.3. What conditions might not hold?  Two important ones are: perfect competition and  perfect information.  Banks may have power in the market, driven by their bigness;  People with investment projects may have more and better information than bankers.  Both of these features drive credit markets away from efficiency. 2.4. If bankers have market power, they will charge more for their services, meaning they  will charge more to borrow money.  This means that some good investments will not get  made: only the super high-value investments will be made, and the ones that are  somewhat high-value, but not super-high-value, will be judged unaffordable by the  people trying to borrow the money. 2.5. If people trying to borrow have private information about the value of their projects, they  will consistently lie in the direction of over-valuing their projects when they are talking to  bankers.  So, bankers will only fund projects that seem to be super-high-value.  Similar  effect as banker market power. 2.5.1. There are some ways out of this problem:  people develop reputations, they put  up collateral or bonds, they find credible ways to convince the banker that they are  a good risk.
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2.6. These market failures (lack of perfect competition, lack of perfect information) make  credit markets inefficient in general. 2.7.
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This note was uploaded on 09/13/2009 for the course ECONOMICS econ 104 taught by Professor Krishnapendakur during the Spring '09 term at Simon Fraser.

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Financial crisis - ECON 104Financial Crisis 1 What is the nature of the current crisis There are 3 big proximate causes a bunch of new and

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