Deck 12: Financial Crises, Panics, and Unconventional Monetary Policy

Question 1

What is the moral hazard problem?

Answer 1

The moral hazard problem is a problem that arises when people don't have to bear the negative consequences of their actions.

Question 2

Explain what herding and leverage are and how they can lead to a bubble.Also explain why leverage can cause the bursting of a bubble to be worse than it otherwise would be.

Answer 2

Herding is the tendency to imitate other behavior.Leverage is the act of borrowing to make financial investments.Both are key factors in the forming of a bubble.What happens is that investors are initially making consistent profits in some assets (like stocks or houses).Others see these consistent profits and follow the crowd (herd) by likewise making investments in these same assets.Eventually, the promise of profits seems so absolute, and the tendency to follow the crowd so strong, that individuals begin to borrow money so that they can invest in these assets, thinking that they can just resell the asset when the loan comes due.The rising price of the assets due to the rising demand confirms the belief among investors that they have found a profitable investment, and it leads to further increases in demand, which leads to still higher prices and so on.
When the bubble finally bursts and prices fall, many people are stuck with assets that are worth less than they thought they would be or, in some cases, less than what they paid for the assets.This is bad enough, but when significant leverage has taken place-when people have borrowed to buy the assets-this decline in their value puts people even further behind, because interest is still owed on the debt.Furthermore, if enough people are not able to repay their debts because of the fall in the price of the assets, the amount of available credit in the economy can be significantly reduced, causing a financial crisis.

Question 3

Why did the bursting of bubbles in 2007 lead to financial meltdowns, rather than just mild recessions?

Answer 3

There are many reasons, but one very important reason is that the financial bubble in 2007 had been inflated through leveraging, which means that people had borrowed significantly to invest in stocks and housing respectively.When the bubble burst, these people could not meet their obligations setting up a chain reaction based on partially self-fulfilling expectations.

Question 4

What are extrapolative expectations?

Question 5

What role do economists' view on special interests play in economists' views on regulation?

Question 6

Define each of the following: the moral hazard problem, the law of diminishing control, and the bad precedent problem.

Question 7

What are quantitative easing tools? Why are they necessary?

Question 8

How can monetary policy be designed to specifically flatten the yield curve?

Question 9

Briefly discuss the leveraging that took place in the early 2000s that caused what could have been simply a bursting bubble to turn into a financial crisis.

Question 10

What are extrapolative expectations, and why are they essential for the formation of a bubble?

Question 11

What is the law of diminishing control?

Question 12

How did the Fed respond to the financial crisis in 2008? How did the federal government respond?

Question 13

What is the Central Bank's primary role in a financial crisis?

Question 14

Give an example of a new regulation that came out of the Great Depression.

Question 15

Why does leverage often become the means by which bubbles are inflated?

Question 16

What is leverage and how can it lead to a financial meltdown?

Question 17

What are three unconventional monetary policies and how do they differ from conventional policies?

Question 18

What are the three general principles that most economists share about dealing with a financial crisis?

Question 19

What is the definition of herding and how does it contribute to bubbles?

Question 20

Why do economists worry more about the collapse of the financial sector than other sectors?

Question 21

How does pre-commitment policy work?