Exam 15: Financial Crises, panics, and Macroeconomic Policy

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When prices stop rising,or begin to fall,many people who were heavily leveraged have a hard time meeting the terms of their loans,so they have to sell the assets for whatever they can get just to make their payments.This rapid selling of the asset-which is occurring all throughout the market-places more downward pressure on the price.

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In stage one of a crisis,a bubble forms.In the second stage of a financial crisis,the bubble bursts.In the third stage of a crisis,instability and uncertainty lead to a financial meltdown.During the 1920s,a stock market bubble formed.People borrowed heavily to invest in the stock market.During October 1929,the stock market bubble burst,and stock prices fell significantly.Because in 1929,deposits were not federally insured,there were runs on banks as people wanted to hoard their cash,which caused even sound banks to fail.During the 2000s,a housing bubble formed.In late 2007,housing prices began to fall and it was clear that the housing bubble had burst,though housing bubbles burst much more gradually than stock market bubbles.In 2008,the massive amount of leverage that financial institutions had taken on due to derivatives and credit default swaps led the failure of banks to spread throughout the economy,and financial institutions hoarded cash.The value of these derivatives and credit default swaps had been tied to rising values in the housing market.

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The second stage of financial recovery is the treatment stage.In this stage,the government tries to use expansionary monetary and fiscal policy to return output and employment to their normal levels.