Deck 15: Financial Crises, panics, and Macroeconomic Policy

Question 1

Explain what herding and leverage are and how they can lead to a bubble.Also explain why leverage can cause the bursting of a bubble to be worse than it otherwise would be.

Answer 1

Herding is the tendency to imitate other behavior.Leverage is the act of borrowing to make financial investments.Both are key factors in the forming of a bubble.What happens is that investors are initially making consistent profits in some assets (like stocks or houses).Others see these consistent profits and follow the crowd (herd)by likewise making investments in these same assets.Eventually,the promise of profits seems so absolute,and the tendency to follow the crowd so strong,that individuals begin to borrow money so that they can invest in these assets,thinking that they can just resell the asset when the loan comes due.The rising price of the assets due to the rising demand confirms the belief among investors that they have found a profitable investment,and it leads to further increases in demand,which leads to still higher prices and so on.When the bubble finally bursts and prices fall,many people are stuck with assets that are worth less than they thought they would be or,in some cases,less than what they paid for the assets.This is bad enough,but when significant leverage has taken place-when people have borrowed to buy the assets-this decline in their value puts people even further behind,because interest is still owed on the debt.Furthermore,if enough people are not able to repay their debts because of the fall in the price of the assets,the amount of available credit in the economy can be significantly reduced,causing a financial crisis.(LO3)

Question 2

What is the definition of herding?

Answer 2

Herding is the human tendency to follow the crowd.

Question 3

What are the three stages of a financial meltdown?

Answer 3

A bubble forms in the first stage; it bursts in the second,causing a recession; in the third stage,the effects of the bursting bubble impact the entire financial system.

Question 4

If an increase in the price of an asset leads people to believe it is a good investment and therefore increases demand for a good,it can create an upward-sloping effective demand curve.Is this a violation of the law of demand?

Question 5

Why did the bursting of bubbles in 1929 and 2007 lead to financial meltdowns,rather than just mild recessions?

Question 6

What are extrapolative expectations?

Question 7

Why does leverage often become the means by which bubbles are inflated?

Question 8

What is leverage and how can it lead to a financial meltdown?

Question 9

When a stock market bubble bursts,what happens to real wealth? What happens to nominal wealth?

Question 10

Using the analogy of treating a heart attack victim,what are the three stages of financial recovery?

Question 11

What is the difference between systemic and nonsystemic risks? Which ones can be insured against,and which ones can't? Why is this?

Question 12

Why do economists worry more about the collapse of the financial sector than other sectors?

Question 13

What made the financial crisis of 2008 and 2009 similar to the Great Depression?

Question 14

How does herding contribute to bubbles?

Question 15

How was the Great Depression different from the financial crisis of 2008 and 2009?

Question 16

What are the three stages of a financial crisis? Summarize the development of the financial crisis that led to the Great Depression,as well as the financial crisis of 2008.

Question 17

Discuss the first two of the three stages of financial recovery with respect to the financial crisis of 2008 and 2009.Give specific examples.

Question 18

What are extrapolative expectations,and why are they essential for the formation of a bubble? If people have extrapolative expectations,what might be true about the effective demand curve for an asset?

Question 19

Define each of the following and give an example of each relating to the rehabilitation stage of financial recovery: the moral hazard problem,the law of diminishing control,and the bad precedent problem.

Question 20

Discuss the recovery from the Great Depression in light of the three stages of financial recovery using specific examples.

Question 21

What is the moral hazard problem?

Question 22

Give an example of how leverage can be used to increase returns.

Question 23

What are systemic risks and why are people slow to perceive them?

Question 24

Give an example of a new regulation that came out of the Great Depression.

Question 25

What is the second stage of financial recovery? What happens in this stage?

Question 26

How did the Fed respond to the financial crisis in 2008? How did the federal government respond?

Question 27

Why is regulation necessary if a bailout is a likely last resort?

Question 28

What is the bad precedent problem?

Question 29

What is the third stage of financial recovery? What happens in this stage?

Question 30

What is the law of diminishing control?

Question 31

What are quantitative easing tools? Why are they necessary?

Question 32

What is the process by which a bursting bubble leads to a financial meltdown?

Question 33

Demonstrate using supply and demand curves how extrapolative expectations can lead to an upward sloping bubble demand.What happens to prices in this market?

Question 34

In what way can leverage accelerate the bursting of a bubble?

Question 35

How can the money multiplier change during a financial crisis? What does this do to the Fed's ability to implement expansionary monetary policy?

Question 36

What is the first stage of financial recovery? What happens in this stage?

Question 37

Suppose the currency-to-deposit ratio is 25% until a financial panic,which causes people to hoard money,and the currency-to-deposit ratio increases to 200%.Given a reserve requirement of 10%,show what would happen to the money multiplier.

Question 38

Briefly discuss the leveraging that took place in the early 2000s that caused what could have been simply a bursting bubble to turn into a financial crisis.

Question 39

How did the treatment stage of the recovery from Great Depression differ from the same stage of recovery from the 2008/2009 financial crisis?

Question 40

Why did most economists believe that the economy could handle the bursting of the housing bubble?

Question 41

Demonstrate graphically and explain with words how extrapolative expectations about falling real demand can lead to ever-shrinking aggregate demand and an upward sloping effective AD curve.