Question

What is meant by a financial crisis? What are sources of a crisis? What is the link between a financial crisis and an economic crisis? What is meant by a contagion effect a financial crisis? How does it spread from one country to another in an open economy?

Answer 1

Any situation where financial assets experience a huge drop in their values, people are unable to pay their debts and financial institutions face shortages of funds can be called a financial crisis. The sources of such a crisis can be varied ranging from overvalued assets/institutions, investor expectations and behaviour, financial market failures, policy and structural changes to even overseas disturbances.

While the financial crisis typically has a major effect on the finance and investment sectors of an economy, an economic crisis involves all the sub-sectors of an economy and has an impact on daily economic activities of people. If a financial crisis is not checked it can turn into a full-blown economic crisis. It can spread from the banking sector, or the currency and capital markets and start affecting the macro-economic variables of the economy. The shock can travel through the economy by affecting the GDP,investment rates and interest rates, inflation rates and real output among other variables.

The contagion effect is a situation where a shock or disturbance in a particular economy spreads out and affects other economies. In an open economy, such a shock can travel through price or exchange rate movements since economies today are connected globally via international trade. When an economy is openly trading with other economies, it faces the risk of instabilities in trading partners affecting its own economy via capital movements or the international trade market.