Final answer:
Taking on too much leverage in business can lead to amplified profits in good times but also greatly magnify losses in downturns, potentially leading to severe financial stress or bankruptcy. Over-leverage can also affect the economy by reducing credit availability, impacting sectors that rely on borrowing. Central banks face a controversial task in moderating leverage cycles to prevent financial crises.
Step-by-step explanation:
The effects of taking on too much leverage in business can be significant and devastating. High leverage means that a firm has borrowed heavily to finance its operations. This can amplify profits during good economic times but can also exaggerate economic downturns. If a business is unable to service its debt due to a downturn or a decline in the value of its assets, this may lead to severe financial stress or even bankruptcy.
Moreover, the financial capital markets and the broader economy can suffer consequences when businesses over-leverage. For example, during the 2008-2009 Great Recession, a decrease in the valuation of assets held by banks led to reduced availability of loans. This contraction in credit availability dealt a significant blow to sectors that depend on borrowed money, such as business investment, home construction, and car manufacturing, and significantly hampered economic activity.
Central banks may consider the impact of such leverage cycles on the economy and may adjust monetary policy to moderate the effects, but these actions are controversial as they involve decisions about whether asset prices are too high or too low. The delicate balance in managing leverage involves ensuring economic growth while preventing unsustainable levels of debt that can lead to financial crises.