Suppose a financial crisis causes many people to close their deposits and withdraw funds from banks....

Suppose a financial crisis causes many people to close their deposits and withdraw funds from banks. Explain what is likely to happen to inflation.

Expert Solution

When financial crisis occurs , people are afraid about the safety of their deposits in banks and other financial institutions , so they tend to withdraw money from them .

bank run occurs when a bank is unable to honour its committements due to large withdrawl rate. since bank keeps only a fraction of amount of the total deposits with it and lend out the rest , it is immediatley not able to honour the huge withdrawls .

this leads to distrust in banks and so bank panic or financial crisis occurs when a large number of banks suffer from such bank runs. this leads to people withdrawing deposits from banks due to the mistrust.

so the capital nd deposits is completely wiped out from the system ie from banks and other financial institutions of the economy. so banks are unable to lend money since they have no deposits , so no loans could be lend . hence there is no money creation .

banks and lenders go bankrupt since there is no money in the system . so central bank ofteb bails out the banks from this financial crisis .

all of this leads to increase in money supply by central bank . an increase in money supply leads to reduiced vlue of currency since its supply has increased. so this leads to inflation ie a rise in prices.

somethimes the inflation rises so many folds that it leads to hyperinflation.

Rahul Sunny answered 2 years ago

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