Download Ch 12: 1.1-4

1.1
A financial crisis typically results in a recession because households and firms cut back their
spending in the face of difficulty in obtaining loans.
1.2
A bank run is the process by which depositors who have lost confidence in a bank
simultaneously withdraw enough funds to force the bank to close. A bank does not have to be
insolvent to experience a bank run. Depositors may mistakenly believe that a bank has
experienced losses and start to withdraw their funds, even though the bank is, in fact, still
solvent.
1.3
A central bank can act as a lender of last resort and the government can insure deposits.
1.4
Currency crises can occur when a pegged (or fixed) exchange rate ends up substantially above
or below the equilibrium rate that would prevail in the absence of the peg. Pegged exchange
rates substantially above the equilibrium rate pose a particularly acute threat of a currency crisis
because the country may have insufficient foreign exchange reserves to maintain the pegged
exchange rate.
Some European countries have been suffering from a sovereign debt crisis because they
experienced recessions and financial crises during 2007-2009 and beyond that increased
government spending and reduced tax revenues, resulting in soaring budget deficits. The
subsequent slow recoveries, along with high budget deficits, caused investors to doubt the
ability of these governments to pay the interest or principal payments on their bonds, leading to
higher interest rates when the governments issue new bonds.
2.1
Bank panics made the Great Depression more severe. Bank failures wiped out some of the
wealth that households and firms had held in bank deposits, thereby reducing spending. In
addition, as some banks failed and most others became more cautious in the loans they made,
households and firms had to reduce spending financed by borrowing.
2.2
As a result of bank runs, banks were forced to sell assets, causing the prices of these assets to
decline. The decline in the prices of these assets caused other banks and investors holding these
assets to suffer losses, leading to additional bank failures and investors going bankrupt. With
the economic downturn worsening, declining spending led to a falling price level. The deflation
increased the real interest rate and the real value of debts, increasing the burden on borrowers
and leading to more loan defaults.
2.3
Power within the Federal Reserve was much more divided than today making it more difficult for
the Fed to act. The Fed was reluctant to rescue insolvent banks, believing that doing so would
encourage risky behavior by bank managers (the moral hazard problem). The Fed failed to
understand that because of deflation low nominal interest rates did not imply low real interest rates,
and the Fed wanted to purge speculative excess, believing that it was necessary for the price level
to fall and weak banks and weak firms to fail before a recovery could begin.
2.4
The Great Depression began in August 1929—two months before the October 1929 stock
market crash. President Hoover did not foresee the bank panics that would magnify the severity of
the recession. Hoover expected that the recession that began in August 1929 would have a length
more typical of other recessions, which means that it would have been reasonable to have expected
it to have been over by June 1930. The Great Depression continued longer than Hoover expected
because of: 1) bank panics, 2) policy mistakes by Congress and the president, including raising
tariffs and taxes, 3) the decline in stock prices that destroyed household wealth and increased the
cost to firms of raising capital, and 4) policy mistakes by the Federal Reserve, including a failure to
stop the bank panics.
3.1
A bubble means that an asset’s price has increased far beyond the asset’s fundamental value.
During the housing bubble many lenders granted mortgages to subprime and Alt-A borrowers.
These mortgages were bundled into mortgage-back securities (MBS), collateralized debut
obligations (CDOs), and similar securities, and sold to investors. Once housing prices started to
fall, many borrowers began to default on their mortgages, causing rapid declines in the value of
mortgage-backed securities. Banks and other financial firms that owned these securities
experienced losses. Eventually, a full-blown financial crisis developed, significantly worsening
the recession that began in December 2007.
3.2
Investment banks borrow short term, particularly in the repo market, and lend some of the funds
long term. When repo borrowers refuse to roll over their loans, the banks must liquidate assets
to repay the loans. In this sense, the repurchase agreement market is similar to traditional bank
deposits. The run on Bear Stearns was an early sign that problems with mortgage-backed
securities might spill over into the financial system as a whole. The run on Lehman Brothers
forced it into bankruptcy. Most economists believe that the failure of Lehman Brothers
worsened the financial crisis and increased the severity of the recession.
3.3
The Federal Reserve: 1) lowered the federal funds rate to almost zero, 2) helped JPMorgan
Chase acquire Bear Stearns, and 3) began buying commercial paper issued by nonfinancial
corporations. The Treasury insured money market mutual fund deposits, and Congress passed
the Troubled Asset Relief Program (TARP), which the Treasury used to inject capital into the
banking system by purchasing stock in banks.
3.5
4.1
a. Investment bank Bear Stearns almost failed because lenders lost faith in the bank’s ability to
pay back short-term loans, so lenders declined to renew Bear’s short-term loans. As a result,
Bear had to liquidate assets in order to pay back these short-term loans.
b. In March 2008, the Federal Reserve arranged a buyout of Bear Stearns by JP Morgan Chase, a
commercial bank. The Fed provided crucial aid to JP Morgan Chase to induce them to purchase
Bear.
c. A debt-deflation process would occur if Bear Stearns went bankrupt and had to sell its assets.
This selling of assets would have pushed down the price of the assets, which other investment
banks were also holding, and would have worsened their balance sheets, which, in turn, could
have accelerated bankruptcies at these firms.
The lender of last resort seeks to stop a bank failure from turning into a bank panic by making
sure solvent institutions can meet their depositors’ withdrawal demands. The too-big-to-fail
policy and the lender of last resort strive to prevent systemic risk, where the failure of a few
firms leads to the widespread failure of solvent banks.
4.2
Innovations to circumvent deposit-rate ceilings included the development of negotiable CDs,
automatic transfer systems (ATS) accounts, money market deposit (MMDA) accounts, and
negotiable order of withdrawal (NOW) accounts.
4.3
Because deposits are insured, banks can focus on increasing the spread between the rates at
which they borrow and lend. Banks can increase the riskiness of their loans and investments
without worrying about whether depositors will withdraw their funds. With deposit insurance,
depositors have no incentive to monitor the behavior of bank managers and to withdraw their
deposits if the managers made reckless investments. Nevertheless, deposit insurance is not
necessarily a bad idea, because deposit insurance has substantially decreased systemic risk in
the commercial banking system in the United States by eliminating commercial bank runs.