Question

1-Briefly discuss how credit bubble can lead to crisis (hint: Japanese banking crisis)

2- Compare and contrast the potential causes of banking crisis for emerging and advanced financial systems. What are the potential preventative measures in each case?

Answer 1

Answer1

Credit bubbles are rapidly change in price of an asset. Asset bubbles exist when market prices in some sector increase over time and trade far higher than fundamentals would suggest. the following points represents assets bubbles:-

• Expansion of the supply of money and credit in an economy provides the necessary fuel for bubbles
• Technological factors, incentives created by public policies, and the particular historical circumstances around a given bubble help to determine which asset classes and industries are the focus of a bubble.
• Market psychology and emotions like greed and herding instincts are thought to magnify the bubble further.
• When bubbles eventually pop, they tend to leave economic pain in their wake including recession or even depression.How Asset Bubbles Can Lead to RecessionAn asset bubble occurs when the price of an asset, such as stocks, bonds, real estate, or commodities, rises at a rapid pace without underlying fundamentals, such as equally fast-rising demand, to justify the price spikeIt is normal to see prices rise and fall over time as buyers and sellers discover and move toward equilibrium in a series of successive trades over time. It is normal to see prices overshoot (and undershoot) the prices implied by fundamentals of supply and demand as this process proceeds, and this can be and has been readily demonstrated by economists in controlled experiments and classroom exercises. Early recipients of the new money are thus able to bid up prices for the assets and goods that they purchase before prices in the rest of the economy rise. This is part of the economic phenomenon known as a Cantillon Effect. When buying activity in the market is focused on a specific asset class of assets or economic goods by the circumstances of the time, then the relative prices of those assets rise compared to other goods in the economy. This is what produces an asset price bubble. The prices of these assets no longer reflect just the real conditions of supply and demand relative to all other goods in the economy, but are driven higher by the Cantillon Effect of the new money entering the economy. Prices normally rise and fall in any market, but they tend toward the fundamental value of the traded goods or assets over time.over time as market participants gain experience and information about market fundamentals and the past series of prices.

ANSWER 2

Financial crisis hit both poor and rich class people. Crisis are, at a certain level, extreme manifestation of the interaction between the fianacial sector and the real economy. poor microeconomics countries leads to financial crises

In a systemtic banking crisis, actual or potential bank runs and failures can induce banks to suspend the convertibility of their liabilities or compel the government to intervene to prevent this by extending liquidity and capital assistance on a large scale. Since these are not so easily measurable variables, they lend themselves more to the use of qualitative methodologies. Other classifications are possible, but regardless the types of crisis likely overlap.

capital account liberalization should also proceed cautiously, in an orderly and progressive manner, given the large risks of financial crises—heightened by international capital market failures— in developing countries. Benefits of capital account liberalization and increased capital flows have to be weighed against the likelihood of crises and their costs. Clearly the benefits from foreign direct investment (FDI) and longer-term capital inflows outweigh the costs associated with the increased likelihood of financial crisis, and developing countries should pursue a policy of openness. But for more volatile debt portfolio and interbank short-term debt flows and the related policy of full capital account convertibility, there are higher associated risks of financial crisis and greater uncertainity about the benefits.

Sterilization may work in the short term, but it is increasingly costly over time. If inflows persist, this strategy becomes even harder to maintain because of rising fiscal costs, reflecting the fact that interest rates on domestic bonds exceed the interest that central banks earn on foreign deposits abroad.Moreover, sterilization leads to higher domestic interest rates, which attract further inflows of capital. Shortterm capital flows—which tend to be the most sensitive to interest rate differentials— increase, raising the vulnerability to liquidity crises.