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Financial Crisis and Subprime meltdown

4 important questions on Financial Crisis and Subprime meltdown

What is a financial crisis?

Financial crises are major disruptions in financial markets characterised by sharp declines in asset prices and firm failures.

What happens in the second stage of a typical finical crisis?

Because of worsening business conditions and uncertainty about their banks health depositors begin to withdraw their funds and a banking crisis (bank panic) ensues. The resulting decline in banks results in a loss of their information capital, worsening adverse selection and morel hazard problems, leading to spiralling down of the economy. When a sorting out of good (solvent banks) from insolvent has taken place, the recovery is set in place

When does a third stage of financial crisis occur?

When economic downturn leads to a sharp decline in prices, the recovery process can be short-circuited. --> debt inflation occurs, in which unanticipated decline in price level sets in, leading to a further deterioration in firms net wort because of increase burden of indebtedness. This can again lead to moral hazard, adverse selection and further economic downturn

Stage 3 of the emerging market crisis (full-fledged financial crisis)

The Decline in the value of the domestic currency causes a sharp rise in the debt burden of domestic firms, which leads to a decline in the firms net worth, as well as increases in inflation and interest rates
Adverse selection and moral hazard problems then worsen, leading to a collapse of lending and economic activity.
The worsening economic conditions and increases in interest rates result in substantial losses for banks, leading to a banking crisis, which further depresses lending and aggregate economic activity.