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Chapter 12: Q.4 (page 343)

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

When the financial fraction increases, the lender finds it difficult to assess the creditworthiness 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.

Step by step solution

01

Definition

Financial fraction is 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

Financial frictions are the stickiness involved in making transactions the total process including time, effort, money, and tax effects of gathering information and making a transaction such as buying a stock or borrowing money.

The most basic concept of financial friction is a spread between the return earned in businesses from the use of physical capital - plant and equipment - and the return earned by savers.

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

03

Final Answer

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

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