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Government's Role in Financial Crises

The government plays a large role in preventing and mitigating financial crises through various fiscal and monetary policies. These include increasing the money supply during economic downturns, adjusting interest rates to influence spending levels, and implementing infrastructure and consumer protections. The government also coordinates national financial policies and responds to global issues. There are several types of financial crises including currency crises from financial liberalization or fiscal imbalances, sudden stops in capital flows, sovereign debt crises from high government debt levels, and banking crises where many banks become insolvent.

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26 views1 page

Government's Role in Financial Crises

The government plays a large role in preventing and mitigating financial crises through various fiscal and monetary policies. These include increasing the money supply during economic downturns, adjusting interest rates to influence spending levels, and implementing infrastructure and consumer protections. The government also coordinates national financial policies and responds to global issues. There are several types of financial crises including currency crises from financial liberalization or fiscal imbalances, sudden stops in capital flows, sovereign debt crises from high government debt levels, and banking crises where many banks become insolvent.

Uploaded by

lcergo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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5. What role do government policies play in preventing or mitigating financial crises?

- p. 335

In the previous chapters, we learned that the government plays a large part in controlling the volatility of
business cycles and aggregate prices as they can develop and impose policies and regulations for
managing and resolving financial crises when they do occur. For instance, all economies are subject to
fluctuating business cycle. To prevent the economy from further collapsing during an economic
downturn, the central bank increases the money supply in order to inject more capital into the economy,
with the aim of spurring higher consumption and investment, which are the driving forces behind
economic growth. However, an uncontrolled spur in the economy results in a run-up in aggregate prices
fueled by demand and exuberant spending to the point of collapse in the long-term. By then, government
can elevate the interest rates to discourage spending among consumers. This is also known as monetary
policy. The government can also influence the boom-and-bust cycles through fiscal policy; that is,
adjusting the tax collection and government expenditure, which affects the capital formation and spending
behavior of households and firms. In addition to fiscal and monetary policy, financial infrastructure,
consumer protection, and micro- and macroprudential policies are some of the national policies the
government can implement to mitigate deflationary spirals. The government also has the power to
coordinate these national policies to respond to global financial policies.

6. What are the different types of financial crises?

a. Currency Crisis – characterized by a sharp decline in domestic currency that resulted from either (1)
financial liberalization (eliminating restrictions on financial institutions and markets) or (2) severe fiscal
imbalances (inappropriate financing of government spending).
b. Sudden Stops – a sudden decline in capital inflows into the emerging market economy, slowdown in
aggregate output caused by external trigger.
c. Sovereign Debt Crisis – a situation characterized by the skyrocketing of government debt with an
elevated debt-to-GDP ratio, resulting from multiple bank bailouts and economic recessions (Eurozone
2007-2008). During this financial crisis, the government is incapacitated to pay back its debts because the
government expenditure is higher than its tax revenue.
d. Banking Crisis – occurs when many financial institutions are about to be insolvent that led some banks
to go out of business. This crisis lead to a bank panic where multiple banks fail simultaneously caused by
asymmetric information as depositors withdraw their deposits to the point that the bank fail due to the fear
of losing their money.

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