Answer: The three stages of a financial crisis are: (1) Initiation of financial crisis, (2) Banking crisis, and (3) Debt deflation.
Explanation: A financial crisis occurs when an increase in asymmetric information from a disruption in the financial system prevents it from channeling funds efficiently. Financial crises in advanced economies have progressed in two and sometimes three stages:
- Initiation of Financial Crisis: This stage involves a shock that causes a decline in asset prices, an increase in uncertainty, or a deterioration in balance sheets of borrowers or financial intermediaries. The shock can be triggered by various factors, such as mismanagement of financial liberalization or innovation, asset-price bubbles, increases in interest rates, fiscal imbalances, or contagion from other countries. The shock leads to an adverse selection and moral hazard problem that reduces lending and investment activity, resulting in a contraction of economic activity.
- Banking Crisis: This stage occurs when the problems in the financial system become more severe and widespread, leading to bank runs, bank failures, or bank insolvencies. Bank runs occur when depositors lose confidence in the solvency of banks and withdraw their funds en masse, causing a liquidity shortage for banks. Bank failures occur when banks are unable to meet their obligations to depositors or creditors. Bank insolvencies occur when banks have negative net worth, meaning that their liabilities exceed their assets. A banking crisis can have a negative impact on the economy by disrupting the payment system, reducing the availability of credit, and lowering the aggregate demand.
- Debt Deflation: This stage occurs when a severe economic downturn leads to a deflationary spiral, meaning that a fall in prices increases the real value of debt, which further reduces spending and prices. Debt deflation can worsen the balance sheet problems of borrowers and lenders, leading to more defaults, bankruptcies, and asset sales. Debt deflation can also increase the real interest rate, which discourages borrowing and investing. Debt deflation can deepen the recession and prolong the recovery.
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