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Inthischapter,youwilllearn: p ,y
common features of financial crises how financial crises can be self-perpetuating various policy responses to crises about historical and contemporary crises, including the U.S. financial crisis of 2007-2009 how capital fli ht often plays a role i fi h it l flight ft l l in financial i l crises affecting emerging economies
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Financial Crises
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Once a crisis starts, it can sustain itself for a long time Financial Crises
CASE STUDY
Financial Crises
Financial Crises
Financial Crises
Financial Crises
Risky Rescues
Risky loans: govt loans to institutions that may not be repaid institutions bordering on insolvency g y institutions with no collateral Example: Fed loaned $85 billion to AIG (2008) Equity injections: purchases of a companys stock by the govt to i t k b th t t increase a nearly i l insolvent l companys capital when no one else is willing to buy the th companys stock t k Controversy: govt ownership not consistent with free market principles; political influence
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Financial Crises
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The flight to safety: BAA corporate bond and 90 day T bill rates 90-day T-bill
An economy in freefall
Falling stock and house prices reduced consumers wealth, reducing their confidence and spending. Financial panic caused a credit crunch: bank lending fell sharply because banks b k could not resell l ld t ll loans t securitizers to iti banks worried about insolvency from further losses Previously safe companies unable to sell y p commercial paper to help bridge the gap between p production costs and revenues
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Federal R F d l Reserve programs to repair commercial t i i l paper market, restore securitization, reduce mortgage interest rates t i t t t
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The aftermath
The financial crises eases Dow Jones stock price index rose 65% from 3/2009 to 3/2010 Many major financial institutions profitable in 2009 Some taxpayer funds used in rescues will probably never be recovered, but these costs recovered appear small relative to the damage from the crisis
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Dec-2007 Jan-2008 Feb-2008 Mar-2008 Apr-2008 May-2008 Jun-2008 Jul-2008 Jul-2008 Aug-2008 Sep-2008 Oct-2008 Nov-2008 Dec-2008 Jan-2009 Feb-2009 Mar-2009 Apr-2009 May-2009 Jun-2009 Jul-2009 Aug-2009
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The aftermath
Constraints on macroeconomic policy Huge deficits from the recession and stimulus constrain fiscal policy p y Monetary policy constrained by the zero-bound p problem: even a zero interest rate not low enough to stimulate aggregate demand and reduce unemployment Moral hazard The rescues of financial institutions will likely increase future risk-taking and the need for future rescues
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Such proposals would reverse the trend toward mergers and conglomeration of financial firms, would reduce benefits from economics of scale & scope
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CASE STUDY
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Capital flight
Interest rates sharply when people sell bonds Exchange rates depreciate sharply when people sell the countrys currency country s Contagion: the spread of capital flight from one country to another occurs when problems in Country A make people worry that Country B might be next, so they sell Country Bs assets and currency, Bs causing the same problems there like a bank panic
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Crisis in Greece
Caused by rising govt debt, fear of default Asset holders sold Greek govt bonds, which caused interest rates on those bonds to rise Facing a steep recession, Greece could not pursue fiscal policy due to debt, or monetary p policy due to membership in the Eurozone y p
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Crisis in Greece
16 14 12 10 8 6 4 2 0 200 05 200 06 200 07 200 08 200 09
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Greece
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CHAPTERSUMMARY
Financial crises begin with asset price declines, financial institution failures, or both. A financial crisis can produce a credit crunch and reduce aggregate demand, causing a recession, which reinforces the financial crisis. Policy responses include rescuing troubled institutions. institutions Rescues range from riskless loans to institutions with liquidity crises, giveaways, risky loans, loans and equity injections injections.
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CHAPTERSUMMARY
Financial rescues are controversial because of the cost to taxpayers and because they increase moral hazard: firms may take on more risk, thinking the government will bail them out if they get into trouble. Over 2007-2009, the subprime mortgage crisis evolved into a broad financial and economic crisis in the U.S. Stock prices fell, prestigious financial institutions failed lending was disrupted and failed, disrupted, unemployment rose to near 10%.
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CHAPTERSUMMARY
Financial reform proposals include: increased regulation of nonbank financial institutions; policies to prevent institutions from becoming too big to fail; rules that discourage excessive risk-taking; and new structures for regulatory agencies. Financial crises in emerging market economies typical include capital flight and sharp decreases in exchange rates, which can be caused by high g government debt, political instability, and banking ,p y, g problems. The International Monetary Fund can p g y help with emergency loans.
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