When asset prices fall following a boom,
A) moral hazard may increase in companies that have lost net worth in the bust.
B) financial institutions may see the assets on their balance sheets deteriorate, leading to deleveraging.
C) both A and B are correct.
D) none of the above are correct.

Question

Quizplus · Accepted Answer

A is correct because companies may become more reckless with their investments if they believe the government will bail them out again in the event of another bust. This is due to moral hazard, where individuals or institutions take excessive risks because they believe they will not bear the full cost of their actions.

B is correct because financial institutions may have used leverage to engage in risky investments during the boom, and the subsequent fall in asset prices may cause the value of these assets to deteriorate, leading to potential losses for the institution. As a result, these institutions may be forced to deleverage, i.e. reduce their overall exposure to risk, by selling off some of their assets or reducing their lending activity.

Therefore, both A and B are correct.

When Asset Prices Fall Following a Boom