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Chapter 12: Q. 4 (page 318)

Define “financial frictions” in your own terms and

explain why an increase in financial frictions is a key

element in financial crises.

Short Answer

Expert verified

Friction between businesses and savers is a result of the return earned by physical capital-plant and equipment-and the return earned by businesses from saving. A rise in the level of financial frictions leads to financial crises, since the whole transaction process gets delayed.

Step by step solution

01

Definition

Financial fractions are defined as when there is a problem with asymmetric information in the financial markets, then it becomes a constraint for the financial markets to efficiently intermediate the funds from savers to productive investment opportunities available.

02

Explanation

When the financial fraction increases, the lender finds it difficult to assess the credit worthiness of the borrowers.

They would increase the interest rates with anticipation that the borrower might not pay back the loan resulting in a higher credit spread.

Thus, financial fraction gradually leads to the financial crisis.

03

Final Answer

Therefore, an increase in financial frictions leads to financial crises as the whole process of the transaction gets delayed.

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