ECON 4200 Chapter 12

Why is a financial crisis likely to lead to a contraction in economic​ activity?

A disruption in the financial system diminishes the flow of funds from savers to borrowers.

How can a bursting of an​ asset-price bubble in the stock market trigger a financial crisis

A reduction in asset prices causes a serious deterioration in borrowing​ firms' balance sheets A reduction in asset prices causes lenders to become more cautious and reduce the amount of loans they make A reduction in asset prices causes borrowing firms to have less to lose so they are willing to take on additional risk

What are the five areas included in the​ Dodd-Frank Act of​ 2010?

Consumer​ protection, resolution​ authority, systemic risk​ regulation, Volcker​ rule, and derivatives.

​__________ occurs when a substantial unanticipated decline in the price level sets​ in, leading to a further deterioration in a​ firm's net worth because of the increased burden of indebtedness.

Debt deflation

Which of the following statements is true of financial​ frictions?

Financial frictions are a set of conditions that prevents financial markets from effectively assigning funds to the best investment opportunities.

Which of the following is not a factor that commonly initiates financial​ crises?

Increases in government regulations that make it harder to manage the risks of financial assets.

How did financial innovations in mortgage markets contribute to the​ 2007-2009 financial​ crisis?

Information technology lowered the cost of packaging numerous subprime mortgages into​ mortgage-backed securities that could be sold in financial​ markets, attracting more funds into mortgage finance. Advances in information technology and new statistical techniques lowered the cost of evaluating the risk of mortgages to subprime borrowers who did not meet the standards for traditional mortgage loans. Borrowers could get mortgage loans with little or no money down and could borrow more money relative to the value of the house they were buying and relative to their incomes than allowed with traditional mortgages.

Choose the components of the shadow banking system. ​ Why is the shadow banking system an important part of the​ 2007-2009 financial​ crisis?

Money market funds Investment banks Hedge funds A decrease of funding from the shadow banking system caused a restriction of lending and a decline in economic activity.

Identify the differences between the United​ States' experiences during the Great Depression and the financial crisis of​ 2007-2009. ​

No bank panic occurred in 2007-2009 as opposed to the Great Depression The source of asset - price increases was different for both episodes

Why is the​ originate-to-distribute business model subject to the​ principal-agent problem?

Once the mortgage broker earns his or her​ fee, the broker does not care if the borrower makes good on his payment The mortgage broker has little incentive to ensure the borrower is​ credit-worthy, since loans will be sold as​ mortgage-backed securities The more volume the broker​ originates, the more he or she makes

Why is it important for the U.S. government to have resolution​ authority?

Resolution authority allows the government to quickly takeover a failing firm.

What is a credit​ spread? Why do credit spreads rise during financial​ crises?

The difference between interest rates on loans to households and businesses and interest rates on completely safe assets such as U.S. Treasury bonds. Credit spreads rise because asymmetric information problems​ increase, making it more difficult to judge the risk of potential borrowers.

A financial crisis occurs​ when:

a particularly large disruption to information flows occurs in financial markets.

How can the​ S&L crisis be blamed on the principal-agent problem? Politicians and​ regulators, who are known as the ?, have not had the same incentives to minimize costs of deposit insurance as do the​ taxpayers, who are known as the ? As a​ result, politicians and regulators​ __________________________, thereby increasing the cost of the​ S&L bailout.

agents politicians relaxed capital​ standards, removed restrictions on holdings of risky​ assets, and engaged in regulatory forbearance