Financial Shocks

Financial shocks, alone or in combination, have a strong propensity to initiate financial crises. Here are the five reasons we know for now.

Increases in uncertainty. When companies and investors concern about the future, they tend to use their money safely. 

Increases in interest rates. Higher interest rates make business projects less profitable, lower the gross domestic product (as we know it's GDP), and also tend to discourage good borrowers. Higher interest rates even hurt cash flow, rendering firms more likely to default.

Government fiscal problems are also crucial since it connects to the value of currencies and the value of relative securities.

Balance sheet deterioration. Whenever a firm’s balance sheet deteriorates, the asymmetric information rears its trio of ugly, fang-infested faces. 

Banking panics. If anything hurts banks’ balance sheets, banks will reduce their lending to avoid going bankrupt and incurring the wrath of regulators, negatively affect the economy by reducing the flow of funds between investors and entrepreneurs. 

A Financial Shock from Recent History

A financial shock that happening recently, is the shocks caused by COVID-19. Obviously, it has already spread worldwide. Before the vaccine actually come out, everything about the economic rebound is all uncertain. Many physical stores are closed because of uncertainty, business owners feel concerned about the future, they tend to reduce their business and run it safely. 

During the hard period, governments are trying to do something to win their supports. However, money does not grow on trees, there are always costs. Financial stimulus policies have become more and more frequent recently and the US government even consider the second stimulus check. But do you really think we have infinite money to spend? Where does this money come from? Of course, from taxes mostly. 

The Federal Reserve also takes actions on this, lower the interest rate during the difficult time. Lowering the interest rate may induce business expansion and so do the GDP, but it is still be blocked by the certainty. Moreover, it also affecting the money demand and gross investment. 

Reference

Gittins, W. (2020, October 24). Second stimulus check update: US coronavirus relief bill. Retrieved October 26, 2020, from https://en.as.com/en/2020/10/24/latest_news/1603567807_242410.html

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

Principle of Finance Aggregate Demand & Aggregate Supply #Notebook

Principle of Finance Aggregate Demand & Aggregate Supply #Notebook

As we have learned from the Macroeconomics, the aggregate demand, and supply, that relates the price level to the total final goods and services demanded (aggregate demand) and the aggregate supply was a new theory developed by economists.

The aggregate demand and supply model can be used to examine both the short and the long run, it's similar to the price theory model of supply and demand, and it gives policymakers the grounds for implementing policies. 

The aggregate supply curve, in the long run, is thought to be vertical at the natural level of output. In the long run, the economy can produce only so much given the state of technology, the natural rate of unemployment, and the amount of physical capital devoted to productive uses.

However, in the short run, prices of final goods and services generally adjust faster than the cost of inputs are often sticky due to long-term contracts fixing their price. 

23.3 Equilibrium Analysis #Notebook

If we start with the AD, AS, and the long term AS curve, their intersection indicates both the price level P* and the output Y*.

At any price > the equilibrium price level, there will be excess supply, so prices will fall toward the equilibrium point.

At any price < the equilibrium price level, there will be excess demand, so prices bid up to the equilibrium point.

The self-correcting mechanism makes many policymakers hard to choose their plans. However, In the long run, we probably are all dead. 

Policymakers often try to discover how to shift Ynrl to the right because, if they can do that, it doesn’t matter how short the long term is. 

People often believe that wars induce long-term economic growth, but they are quite wrong. Empirically, wars are indeed often followed by recessions and deflation. Although wars do indeed speed research and development, it is not worth the wartime destruction of great masses of human and physical capital.

During the war, the output increase because of increases in G (war products, tanks, guns.) and I (new or improved factories to produce war gears.). Due to the right shift in AD, the price level also rises, it's the illusion of wealth. After the war, both lower output and the AD leftward shift decreases the price level. 

23.4 The Growth Diamond #Notebook

By reducing asymmetric information and tapping economies of scale, the financial system efficiently links investors to entrepreneurs, ensuring that society’s scarce resources are allocated to the highest valued uses and that innovative ideas get a fair trial.

In the growth diamond, the home plate is represented by government, first base by the financial system, second base by entrepreneurs, and third base by management. 

To succeed economically, a country must first possess a solid home plate, a government that protects the lives, liberty, and property of its citizens. 

Next, it must develop an efficient financial system capable of linking savers and investors to people with good business ideas, and entrepreneurs.

The managers at third take over after a product has emerged and matured.

The growth diamond is powerful and can be applied to almost every country on earth. 

23.5 Financial Shocks #Notebook

Financial shocks, alone or in combination, have a strong propensity to initiate financial crises:

Increases in uncertainty. When companies and investors concern about the future, they tend to use their money safely. 

Increases in interest rates. Higher interest rates make business projects less profitable, lower the gross domestic product (GDP), and also tend to discourage good borrowers. Higher interest rates even hurt cash flow, rendering firms more likely to default.

Government fiscal problems are also crucial since it connects to the value of currencies and the value of relative securities.

Balance sheet deterioration. Whenever a firm’s balance sheet deteriorates, the asymmetric information rears its trio of ugly, fang-infested faces. 

Banking panics. If anything hurts banks’ balance sheets, banks will reduce their lending to avoid going bankrupt and incurring the wrath of regulators, negatively affect the economy by reducing the flow of funds between investors and entrepreneurs. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.