Question

In this class we have studied numerous financial crises in developing
countries. While each of these crises is different, there are patterns that
re-occur and mistakes that are repeated over and over again.
1) Define and discuss what is a financial crisis? (Hint: there is no
definitive answer.)
2) Why are developing countries more vulnerable to financial crises?
3) What is the typical pattern for a financial crisis?
4) What role has the IMF played in financial crises in developing
countries? Specifically, what policies do the IMF typically
recommended? What are the positive and negative consequences of
these policies (discuss both).
5) Design specific steps and institutions to help developing countries
deal with financial crises.
a) What changes to domestic financial institutions can developing
countries take to minimize the chances of a financial crisis?
b) Should developing countries limit capital inflows or outflows or
impose a (Tobin) tax on financial transactions?
c) How would you reform the IMF to make it more able to deal with
financial crises? (Be realistic and assume their overall budget
stays the same.)
d) What modifications to the international banking system or credit
rating system would you recommend?
6) In your conclusion please synthesize your critique and
recommendations.

Answer 1

1) Define and discuss what is a financial crisis?

Answer:

A financial crisis is said to happen when the situations are such in which the value of financial institutions or value of financial assets drop at a great pace. In this case some of the financial assets rapidly lose a large part of their nominal value. In this situation, the supply of money is much higher compared to the demand for money which leads to result in a loss of paper wealth.

A financial crisis is said to occur when financial institutions or assets are overvalued combined with irrational behaviour from investors. A rapid string of selloffs can further result in lower asset prices or more savings withdrawals. If a check on financial crisis is not put the entire economy can go into a recession.

2) Why are developing countries more vulnerable to financial crises?

Answer: Developing countries are more vulnerable to financial crisis. Financial Crisis leads to decline in growth rates of any economy but what make things worse in a developing nation is the already existent high level of poverty. This exposes the households much more in a developing nation compared to the developed economies. They experience high level of negative consequences not just in short run but also in long run. In the developing nations, even the government has its constraints to ease of the negative impacts because of limited institutional capacity and limited amount of fiscal resources.

3. What is the typical pattern for a financial crisis?

Answer: There is a typical pattern for a financial crisis. There is an innovation or a new technology is discovered which leads to economic expansion in an economy. With economic expansion comes increase in consumption and investment as a consequence. At the same time credit is increased and interest are lowered. All this means an increase in wealth in an economy and people look for various investment sources to invest this wealth in. They can invest in different assets be it bonds, stocks real estate or any commodity, which huge investments poring in, the prices of the assets increase creating an asset bubble. This bubble continues to expand till there comes a situation which pricks this bubble usually referred as market correction or a financial crash. The situation leads to rapid deflation and rise in credit defaults which damage the entire banking and financial system. With the loss of wealth and reduced access to credit, the demand for consumption and investment reduces further leading to slow down or financial crisis in the economy.

4) What role has the IMF played in financial crises in developing countries? Specifically, what policies do the IMF typically recommended? What are the positive and negative consequences of these policies (discuss both).

Answer: Role of IMF:

IMF role can be any of the two:

1. Role of judiciary and legal infrastructure for private bankruptcy. It acts as an international bankruptcy court or an international creditor delegate

2. Role of Lender of Last Resort (LOLR) function for the financial system.

In most of the cases IMF acts as a creditor. The formal powers and the effective governance mechanisms of the IMF, G-7 members are in true command of IMF.

Both these roles create a classic temporal inconsistency problem. These action paths by IMF are considered optimal before the financial crisis but once it happens these incentives change dramatically when the event occurs.

IMF maintains a crucial balance between crisis prevention measures and crisis management measures.