Professional Documents
Culture Documents
and the
FINANCIAL SYSTEM
N. Gregory Mankiw
& Laurence M. Ball
CHAPTER
Financial
Crises
19
Modified for EC 204
by Bob Murphy
CHAPTER 19
Financial Crises
Financial Crises
CHAPTER 19
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CHAPTER 19
Financial Crises
Once19
a
CHAPTER
CASE STUDY
Financial Crises
Financial rescues:
emergency loans
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Costs of bailouts
direct: use of taxpayer funds
indirect: increases moral hazard, increasing
likelihood of future failures and need for future
bailouts
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Financial Crises
Financial Crises
Risky Rescues
Risky loans: govt loans to institutions that may not
be repaid
institutions bordering on insolvency
institutions with no collateral
Example: Fed loaned $85 billion to AIG (2008)
Financial Crises
2007-2009:
stock prices dropped 55%
unemployment doubled to 10%
failures of large, prestigious institutions like
Lehman Brothers
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Financial Crises
Financial Crises
Lehman Brothers
declared bankruptcy, also due to losses on MBS
Lehmans failure meant defaults on all Lehmans
borrowings from other institutions, shocked the
entire financial system
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Flight to safety
People sold many different kinds of assets, causing
price drops, but bought Treasuries, causing their
prices to rise and interest rates to fall to near zero
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An economy in freefall
Falling stock and house prices reduced consumers
wealth, reducing their confidence and spending.
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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
appear small relative to the damage from the
crisis
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The aftermath
Constraints on macroeconomic policy
Huge deficits from the recession and stimulus
constrain fiscal policy
Monetary policy constrained by the zero-bound
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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CASE STUDY
Capital flight
Interest rates rise sharply when people sell bonds
Exchange rates depreciate sharply when people
sell the countrys currency
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Financial Crises
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
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Financial Crises
CHAPTER SUMMARY
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.
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Financial Crises
CHAPTER SUMMARY
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.
Financial Crises
CHAPTER SUMMARY
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