EC223 Lecture Notes - Lecture 15: Monetary Policy, Bear Stearns, Freddie Mac
Document Summary
Financial crisis occurs when there is a large disruption to information flows in financial markets. The result is that financial frictions increase sharply and financial markets stop functioning: asymmetric information problems (moral hazard and adverse selection) If financial markets stop functioning, broad economic activity can collapse. Dynamic of financial crises in advanced economics: stage one- initial phase. Lenders may not have the expertise, or incentive, to manage risk appropriately in new lines of business; or scale outstrips their ability to screen and monitor. Deterioration in financial institution balance sheets: eventually, losses on loans mount, net worth deteriorates, so financial institutions begin process of deleveraging (cutting back on lending) Deleveraging: financial institutions cut back on their lending as a result of less capital (credit freeze, credit crunch) Financial institutions stop collecting information, this leads to higher moral hazard and adverse selection problem. As loans become scarce, business investment decreases and the economy contracts.
