Question

What kind of policies should central banks use to prevent crises?

Answer 1

What are asset bubbles?
Asset bubbles are those asset whose price rises rapidly. However, there is no valuation of the asset that justfied the rise in the price of the asset. It is to be noted that these prices keeps on rising and crosses the market equilibrium and even after doing that, they dont stop. They continue rising. Eventually, these bubbles pop and when it happens economy follows a recession. People keep on buying these asset because of money supply by the central bank. However, once these assets fall, the money of people falls. There is recession in bank sector as money supply is lost, people defaul on payments. For example, 1920 US stock market bubble and 1990 dot-com bubble. These all resulted in recession.
What are financial accelerator?
Financial accelerators refers to that condition where the fall in economy impacts the financial market adversely. This happens because of deteriorating prices of the assets. If the economy is falling or there is an adverse effect on the economy, how financial markets will be affected? The firms that produced various services and good required funds to be able to operate. These funds are financed by external entities such as banks, financial services company etc. However, the require some kind of collatoral for the security of the loan/finance extended to firms. These collatorals are usually in the form of assets. However, when the economy falls, the price of the asset declines as the market is falling too. The balance sheet is worsened and this does not stop here. Since you are not able to fund your operations, you stop those operations and economy falls further. This becomes a vicious cycle. This leads to recession.
Policies central bank use to prevent crisis.
1) Mantaining money supply : The best central bank can do is mantaing money supply in the economy. During condition like Asset Bubble, people keep on investing even after the market equilibrium for that asset is reached? How people are able to keep investing? Ofcourse they like the idea of asset they are investing in but also they are getting enough money supply from the central bank. Therefore, central bank should curb the money supply by increasing the lending rates and selling open market operation bonds in the market.

During condition like financial accelerator, the central bank can increase the money supply as banks are not willing to lend loan and their is suppressed money supply. Central bank should be willing to decrease the lending rates and buy open market operation bonds in the market.

2) Acting as a Guarantor : The central bank take gaurantee of the amount the banks are lending to firms. This guarantee can act as a collatoral to the banks who are lending.

Also, the bank can guarantee to purhcase stressed asset at very low price and huge quantity, this will increase the demand of these asset and mantaing the stability of the price.
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