Financial frictions and explain why an increase in financial frictions a key element in financial crises

Full Answer Section

Scenario 2: Asymmetric information:

Now, if you believe the dealer knows more about the car's condition (potentially hidden flaws), you face an adverse selection problem. They might try to sell you a lemon disguised as a good car. To compensate for this information disadvantage, you would either:

• Demand a lower price (e.g., $18,000) to account for the potential risk of hidden problems.
• Walk away from the deal and seek a car from a more trustworthy source.

The specific price you're willing to pay depends on your risk tolerance and how much trust you have in the dealer.

2. Financial Frictions and Crisis:

Financial frictions: These are obstacles that hinder the smooth functioning of financial markets. They can include:

• Information asymmetries: One party (e.g., borrower) has more information than the other (e.g., lender).
• Transaction costs: Fees and commissions associated with financial transactions.
• Regulation and legal limitations: Restrictions on certain financial activities.
• Market illiquidity: Difficulty buying or selling assets quickly and easily.

**Increased financial frictions play a key role in financial crises because they: **

• Amplify uncertainty: When information is difficult to obtain, trust declines, and uncertainty about future economic conditions increases. This makes lenders less willing to lend and borrowers less willing to borrow, reducing the flow of credit.
• Exacerbate adverse selection and moral hazard: In periods of financial stress, bad borrowers are more likely to seek loans (adverse selection). Additionally, borrowers may engage in riskier behavior after receiving a loan knowing it might be difficult to repay (moral hazard).
• Lead to market illiquidity: As lenders become cautious, assets become harder to sell quickly, even for solid borrowers. This further restricts credit availability and amplifies the crisis.

General uncertainty due to a major financial institution failure:

• Reduces trust in the financial system: This can lead to widespread panic and a reluctance to lend or invest, further tightening credit and amplifying the crisis.
• Increases information asymmetry: The failure may reveal hidden problems within the financial system, making it even harder for lenders to assess risk and borrowers to access financing.
• Triggers adverse selection and moral hazard: Borrowers in weaker financial positions may become more desperate and seek loans they wouldn't qualify for in normal times, while others may take on excessive risk knowing the system is already stressed.

Overall, financial frictions act as a multiplier for negative economic shocks, transforming them into full-blown financial crises.

3. Fed Bond Sale to First National Bank:

T-accounts:

Before:

After:

Changes:

• The Fed's reserves decrease by $2 million as they sell the bonds.
• The Fed's holdings of government securities increase by $2 million.
• First National Bank's reserves increase by $2 million from purchasing the bonds.
• The monetary base (sum of currency in circulation and bank reserves) remains unchanged as the change in reserves at the Fed is exactly offset by the increase at the bank.

4. Deposit Shift from Banks to Currency:

Analysis:

A shift from deposits to currency increases the demand for currency but doesn't affect the supply. In the market for reserves:

• Demand for reserves decreases: Banks hold fewer reserves as their deposit base shrinks.
• **Supply of reserves remains constant

Sample Answer

1. Used Car Market Negotiation:

Scenario 1: Symmetric information:

In this scenario, you and the dealer have the same information about the car's true value. Since the range is $20,000 - $24,000 and the values are symmetrically distributed, the fair price and the car's expected value would be the midpoint: $22,000. You wouldn't be willing to pay more than that, as you can find equivalent cars for that price elsewhere.