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Test 3 notes - Test 3 Chapter 9-Financial Crisis and the...

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Test 3 14:52 Chapter 9-Financial Crisis and the Subprime Meltdown Financial Crisis Key factor= asymmetric information A financial crisis occurs when problems associated with asymmetric information become severe and make channeling funds extremely difficult. Malfunctioning financial markets lead to contraction in economic activity. 6 Factors to Financial Crisis 1. Asset market effects on borrowers’ B/S a. Stock market decline a.i. Decreases the net worth of corporations a.ii. Net worth = assets – liabilities a.ii.1. Net worth is used as collateral a.iii. Lenders have less protection against the consequence of adverse selection (since net worth ~ collateral) a.iv. Lenders become reluctant to lend corporations a.v. In addition, since corporations now have less to lose, they have more incentives to invest on more risky projects, causing the moral hazard problem worse. a.vi. Lending becomes less attractive b. Unanticipated decline in the price level b.i. Most of debt contracts are written in nominal terms (not a contingent plan) b.ii. Unanticipated decline in the price level raises the value of borrowing firms’ liabilities in real terms, but leaves the real value of firms’ asset unchanged.
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b.iii. In real terms, the firms’ net worth declines. b.iv. Adverse selection and moral hazard are more likely b.v. Depressed lending and thus aggregate economic activity. c. Unanticipated depreciation of the domestic currency c.i. In developing countries, most debt contracts are foreign-currency-denominated c.ii. Unanticipated depreciation of domestic currency increases the debt burden of domestic firms c.iii. However, assets are mostly denominated in domestic currency and thus they are unaffected. c.iv. As a whole, this causes a decline in net worth and the economy follows the same patterns. 2. Deterioration in financial institutions’ B/S a. A deterioration in their balance sheet (e.g., incurring huge losses, asset write-downs) = a substantial reduction in their capital b. Fewer resources to lend because recapitalization would be difficult lending declines (deleveraging) 3. Banking crisis a. Banks do not carry enough cash that will meet with all requests for withdrawal b. Fear for the safety of deposits can cause a bank panic, in which multiple banks, including healthy ones, fail simultaneously. c. Asymmetric information (not knowing the quality of banks’ loan portfolios) is the source of the contagion. d. A bank panic causes a reduction in lending (to retain cash) which in turn, increases adverse selection and moral hazard. 4. Increases in uncertainty a. Possible sources of uncertainty
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a.i. Failure of financial or nonfinancial institutions a.ii. Stock market crash and higher volatility
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This note was uploaded on 02/15/2012 for the course ECON 2035 taught by Professor Stahl during the Spring '08 term at LSU.

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Test 3 notes - Test 3 Chapter 9-Financial Crisis and the...

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