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The financial sector and crises

6 important questions on The financial sector and crises

Describe the pre-crash equilibrium

1. Both savers and borrowers are exactly achieving their wealth targets.
2. Borrowers have borrowed the maximum possible which is the loan to value ratio multiplied by the capital gain on their housing in the previous period.
3. The central bank has set the policy rate such that output is at constant inflation equilibrium.

Describe the loan-to-value effect during a balance sheet recession

Retail banks reduce their loan-to-value ratio in response to the fall in the value of their assets. This implies a fall in AD.

Describe the collateral effect during a balance sheet recession

The value of potential collateral is reduced. This has the effect of reducing loans for consumption with a multiplier effect on AD.

Describe the balance sheet effect during a balance sheet recession

AD falls as the increase in spending by saver households is not sufficient to offset the reduction in spending by borrower households.

Describe the effect of rebuilding target wealth

AD will be depressed because saver and borrower households have the desire to rebuild their wealth back towards the target level.

Describe the policy implications that the model of a balance sheet recession highlights

1. Fiscal stimulus can be effective by boosting AD in order to give the private sector time to repair their balance sheets.
2. The increase in government debt can then be repaid once the deleveraging process is over.
3. Although fiscal stimulus is called for in a balance sheet recession when the private sector is trying to save more, the very same balance sheet problems dampen the size of the multiplier.