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Chapter 12: Q.1 (page 343)

How does the concept of asymmetric information help to define a financial crisis?

Short Answer

Expert verified

Financial frictions caused by asymmetric information during a financial crisis can halt or severely disrupt funds flow, with detrimental outcomes for the economy.

Step by step solution

01

Concept introduction

Asymmetric information occurs when one party possesses more information than the other, allowing that party to gain an advantage over the information-inferior party. =There is a financial crisis when there is an unusually large disruption of the flow of information in financial markets. As a result, funds cannot be channeled to households and firms that can make use of them.

02

Explanation 

In financial transactions, the problem of information asymmetry is often prevalent. It generally does not hinders the efficient working of the financial system. However, it can cause problems during a financial crisis as the information asymmetry is intensified. The financial frictions caused by information asymmetry cause the flow of funds to be hindered. this can adversely impact economic activity.

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Most popular questions from this chapter

What is a credit spread? Why do credit spreads rise significantly during a financial crisis?

How did a decline in housing prices help trigger the subprime financial crisis that began in 2007 ?

Identify two similarities and two differences between the Great Depression and the global financial crisis of 2007–2009.

. Go to the St. Louis Federal Reserve FRED database, and find data on house prices (SPCS20RSA), stock prices (NASDAQCOM), a measure of the net wealth of households (TNWBSHNO), and personal consumption expenditures (PCEC). For all four measures, be sure to convert the frequency setting to “Quarterly.” Download the data into a spreadsheet, and make sure the data align correctly with the appropriate dates. For all four series, for each quarter, calculate the annualized growth rate from quarter to quarter. To do this, take the current-period data minus the previous-quarter data, and then divide by the previous quarter data. Multiply by 100 to change each result to a percentage, and multiply by 4 to annualize the data.

a. For the four series, calculate the average growth rates over the most recent four quarters of data available. Comment on the relationships among house prices, stock prices, net wealth of households, and consumption as they relate to your results.

b. Repeat part (a) for the four quarters of 2005, and again for the period from 2008:Q3 to 2009:Q2. Comment on the relationships among house prices, stock prices, net wealth of households, and consumption as they relate to your results, before and during the crisis.

c. How do the current household data compare to the data from the period prior to the financial crisis, and during the crisis? Do you think the current data are indicative of a bubble?

Why would haircuts on collateral increase sharply during a financial crisis? How would this lead to fire sales on assets?
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