Discuss the core concept of Hyman Minsky’s financial instability hypothesis.

In this context
explain the stages which lead a stable economy towards instability

Answer 1.
The core concept of hyman minsky’s financial instability hypothesis is that Stability breeds
instability or Instability is an inherent byproduct of stability.

How economies go from stability to instability

 Traditionally, bank lending is secured against assets. The lending is hedged against
default. For example, banks lend mortgages if people can raise a deposit and can
maintain mortgage payments to repay both the capital and interest. Typically banks
would also check strict lending criteria to make sure the mortgage is affordable.
 However, if house prices rise and there is economic growth, both lenders are
borrowers become more optimistic and willing to take on greater risks.
 Banks insist on smaller deposits and are willing to lend bigger multiples of income.
 Lending becomes more leveraged.
 The greater lending itself causes asset prices to rise and this increases confidence even
further. People keep expecting rising prices – the past becomes the guide to the future.
 We could term these sentiments as ‘Irrational exuberance‘ There is a feeling that the
crowd can’t be wrong. If everyone expects asset prices to keep rising, it’s easy to
jump on the bandwagon.
 Rather than hedge borrowing (safe secured lending) we see a growth of speculative
lending and even ‘Ponzi borrowing’. This means banks and financial institutions lend
money in the hope that asset prices keep rising to enable repayment. However, the
loans of a Ponzi nature are unsustainable in the long term.
 Regulatory capture. Regulators who should be insisting on safe lending levels also get
caught up in the irrational exuberance. Credit rating agencies make mistakes in
allowing speculative and Ponzi borrowing.
 However, this asset bubble and speculative lending cannot be maintained forever. It is
based on the unreasonable expectation that asset prices keep rising beyond their real
value. When asset prices stop rising, borrowers and lenders realise their position has
left them short – they don’t have enough cash to meet their repayments. Everyone
tries liquidity their assets to meet their borrowing requirements. This leads to a loss of
confidence and credit crunch.

Minsky Moment

The Minsky moment refers to the point where the financial system moves from stability to
instability. It is that point where over-indebted borrowers start to sell off their assets to meet
other repayment demands. This causes a fall in asset prices and loss of confidence. It can
cause financial institutions to become illiquid – they can’t meet the demand for cash. It may
cause a run on the banks as people seek to withdraw their money. Usually, the Minsky
moment comes when lending and debt levels have built up to unsustainable levels. It can lead
to a balance sheet recession.

Using a diagram, explain Minsky’s income debt relations.

Answer 2

Hedge financing units are those which can fulfill all of their contractual payment obligations
by their cash flows: the greater weight of equity financing in the liability structure, the greater
the likelihood that the unit is a hedge financing unit.”
 • “Speculative finance units are units that can meet their payment commitments on ‘income
account’ on their liabilities, even as they cannot repay the principal out of income cash flows.
Such units need to ‘roll over’ their liabilities: (e.g., issue new debt to meet commitments on
maturing debt). Governments with floating debts, corporations with floating issues of
commercial paper, and banks are typically hedge units.”

• “For Ponzi units, the cash flows from operations are not sufficient to fulfill either the
repayment of principal or interest due on outstanding debts by their cash flows from
operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to
pay interest (and even dividends) on common stock lower the equity of a unit, even as it
increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances
lower the margin of safety that it offers the holders of its debts.”

Explain the role of government during economic crisis

Answer 3

In a country, the government influences economic activity through two approaches: monetary
policy and fiscal policy.

Through monetary policy, the government exerts its power to regulate the money supply and
level of interest rates. Through fiscal policy, it uses its power to tax and to spend.

To counter a recession, the government uses expansionary policy to increase the money
supply and reduce interest rates. With lower interest rates, it’s cheaper to borrow money, and
banks are more willing to lend it. We then say that money is “easy.” Attractive interest rates
encourage businesses to borrow money to expand production and encourage consumers to
 buy more goods and services. In theory, both sets of actions will help the economy escape or
come out of a recession.

Fiscal policy relies on the government’s powers of spending and taxation. Both taxation and
government spending can be used to reduce or increase the total supply of money in the
economy—the total amount, in other words, that businesses and consumers have to spend.

When the country is in a recession, the appropriate policy is to increase spending, reduce
taxes, or both. Such expansionary actions will put more money in the hands of businesses and
consumers, encouraging businesses to expand and consumers to buy more goods and
services. When the economy is experiencing inflation, the opposite policy is adopted: the
government will decrease spending or increase taxes, or both. Because such contractionary
measures reduce spending by businesses and consumers, prices come down and inflation
eases.

Explain the role of government and the central bank in controlling a recession from spiralling out.
Why is inflation a threat?
Answer 4

Part-1 Same as Answer 3

Part 2-

Stagflation is term that describes a "perfect storm" of economic bad news: high
unemployment, slow economic growth and high inflation. The term was born out of the
prolonged economic slump of the 1970s, when the United States experienced spiking
inflation in the face of a shrinking economy, something economists had previously thought to
be impossible.
The word stagflation is a contraction of "stagnant" and "inflation." When the economy is
stagnant, it means that the gross domestic product (GDP) -- the standard measure of a nation's
total economic output -- is either growing at a very slow rate or shrinking. The natural result
of economic stagnation is increased unemployment. Businesses lay off employees to save
money, which in turn decreases the purchasing power of consumers, which means less
consumer spending and even slower economic growth.
Economic slowdowns are a normal part of the macroeconomic cycle [source: Samuelson].
When financial speculation gets out of hand (as it did with the technology stocks of the late
1990s and the housing market of the mid-2000s), the market needs to stabilize itself. This
usually happens through a temporary, if painful, recession.
But here's the difference between a recession and stagflation: The prolonged period of slow
economic growth is coupled with high rates of inflation. Inflation is the ongoing increase in
prices for goods and services, but it can also be described as an ongoing decrease in the
buying power of money. In a normal year, inflation might rise two or three percentage points.
If the rate of inflation begins to rise past 5 or even 10 percent, things can get hairy.
This is why stagflation is so dangerous. Imagine a scenario in which you have both a sinking
economy and runaway inflation. With high unemployment, consumers have less money to
spend. Add inflation, and the money they do have is worth less and less every day. If you're
on a fixed income, inflation erodes the value of your monthly check. And if you've managed
to save some money, inflation eats away at its value, too. Inflation is a real confidence killer
in an already depressing economic environment [source: Ryan].
Prior to the 1970s, economists thought it was impossible to have both a stagnant economy
and high inflation. According to the economic principles of John Maynard Keynes, an
 influential British economist, inflation was a byproduct of economic growth. For Keynesians,
it's all about supply and demand. When demand is high -- as it is during a booming economy
-- then prices go up.
What the Keynesians didn't realize was that there were other powerful economic forces that
could throw inflation into an upward spiral. To really understand how stagflation works, you
have to take a trip back to the 1970s. Read on to learn more about this economically
depressing decade of oil embargos, brownouts, gas lines and crazy inflation.

Causes of Great Depression

Answer 5

It was not just one factor, but instead a combination of domestic and worldwide conditions
that led to the Great Depression. As such, there is no agreed upon list of all its causes. Here
instead is a list of the top reasons that historians and economists have cited as causing the
Great Depression. The effects of the Great Depression were huge across the world. Not only
did it lead to the New Deal in America but more significantly, it was a direct cause of the rise
of extremism in Germany leading to World War II.
1. Stock Market Crash of 1929 - Many believe erroneously that the stock market crash that
occurred on Black Tuesday, October 29, 1929 is one and the same with the Great Depression.
In fact, it was one of the major causes that led to the Great Depression. Two months after the
original crash in October, stockholders had lost more than $40 billion dollars. Even though
the stock market began to regain some of its losses, by the end of 1930, it just was not enough
and America truly entered what is called the Great Depression.
2. Bank Failures - Throughout the 1930s over 9,000 banks failed. Bank deposits were
uninsured and thus as banks failed people simply lost their savings. Surviving banks, unsure
of the economic situation and concerned for their own survival, stopped being as willing to
create new loans. This exacerbated the situation leading to less and less expenditures.
3. Reduction in Purchasing Across the Board - With the stock market crash and the fears
of further economic woes, individuals from all classes stopped purchasing items. This then
led to a reduction in the number of items produced and thus a reduction in the workforce. As
people lost their jobs, they were unable to keep up with paying for items they had bought
through installment plans and their items were repossessed. More and more inventory began
to accumulate. The unemployment rate rose above 25% which meant, of course, even less
spending to help alleviate the economic situation.
4. American Economic Policy with Europe - As businesses began failing, the government
created the Smoot-Hawley Tariff in 1930 to help protect American companies. This charged
a high tax for imports thereby leading to less trade between America and foreign countries
along with some economic retaliation.
5. Drought Conditions - While not a direct cause of the Great Depression, the drought that
occurred in the Mississippi Valley in 1930 was of such proportions that many could not even
pay their taxes or other debts and had to sell their farms for no profit to themselves. The area
was nicknamed "The Dust Bowl." This was the topic of John Steinbeck's The Grapes of
Wrath.

How government intervention helped to elevate the Great Depression (Diagram of AD,AS)
Answer 6

What happened in 1930’s

The government’s response to the Great Depression, beginning in 1933, marked a major
change in the role of the government in the economy. For the first time, the government took
what is called an “activist role”, attempting to use its powers to generate better economic
times. While we cannot go into great detail here about the reforms, called the New Deal, we
can highlight several important points. First, the government at first saw the falling prices
and the falling wages as the cause of the problem, rather than being a result of the
problem. As a result, the National Industrial Recovery Act (later declared unconstitutional)
was passed to help companies create price floors on their products. The Wagner Act was
passed, aiding the ability of workers to form labor unions. With stronger unions, it was
believed that wages would not decline. And the Agricultural

Adjustment Act was passed, creating the price floors for agricultural products.

Second, the government created a series of programs designed to put people to

work. For example, the Works Progress Administration and the Public Works
Administration created employment opportunities building sewers, roads, bridges, water
systems, Post Offices, and so forth. Several large dams were built in the Northwest to
provide electric power. The Tennessee Valley Authority generated electric power for rural
households. The list of such agencies is a long one.

Third, the government took action to make the banks safer for depositors. The
main such action was the creation of the Federal Deposit Insurance Corporation
(FDIC). The FDIC insures bank accounts against bank failures. The current limit is
$100,000 per account. This prevents runs on banks, since all money in an account is
protected even if the bank fails. Since the creation of FDIC, there has been virtually no risk
to having accounts at banks.

Fourth, there was the creation of what has been called the “Welfare State”. The
best known of these programs was the creation of Social Security in 1935. We will discuss
the social security system in detail in Chapter 16. Additional Welfare State programs that
were created in this period include Unemployment Compensation and Aid to Families
with Dependent Children (AFDC). AFDC was a large part of what most people called
“welfare” until it was replaced in 1996. One aspect of the Welfare State that was not created
 in this period was the provision of medical care for elderly people. Medicare did not come
into existence until 1965.

Finally, since the government was now going to actively attempt to influence
economic results, there needed to be an ability to control the American money supply. As a
result, the connection to gold was severed in 1934 as the United States went off the Gold
Standard. Since 1934, there has been no connection between the number of dollars in
existence and the amount of gold held by the government. Until the 1970s, Americans could
not even own gold except for uses such as jewelry and dental fillings. The American money
supply is under the control of the Federal Reserve System (FED), whose powers were
strengthened in 1935.

Explain using a diagram, How an active government intervention combated the great
depression.
Answer 7- Same as Answer 6

___________________________________________________________________________

In the context of Great Depression, Discuss the relevance of Hymen Minsky’s financial
instability hypothesis.
Answer 8

__________________________________________________________________________

“Although a budget deficit can be dangerous in the long run, sometimes it is only essential in
the short run”. Explain/Evaluate the above statement.

Answer 9

Interest Rates

1. The government needs to increase spending/ transfer payments

2. Cant tax (unpopular)
3. So it borrows(budget deficit)
4. Finance the deficit by printing money
5. Interest rate will fall
Depreciation

1. Increase in supply of domestic currency on the foreign exchange market.

2. Domestic currency will depreciate (floating exchange rate)

Inflation

1. Rising money supply will increase aggregate demand

2. Inflation
 Explain Currency Crisis and how it is quantified.
Answer 10

Currency Crisis is a speculative attack on the foreign exchange value of a currency that either
results in a sharp depreciation or forces the authorities to defend the currency by selling
foreign exchange reserves or raising domestic interest rates.

Quantifying of currency crisis can be said as a nominal depreciation of the currency by at

least 30%, that is 10% depreciated compared to last year. Also increase in Real exchange rate
can lead to depreciation of currency leading to currency crisis.

Using 3 generation model explain the reasons behind currency crisis.

Answer 11.

Currency crises have been the subject of an extensive economic literature, both theoretical
and empirical. Theoretical models of currency crises are often categorized as first, second, or
third generation, though many models combine elements of more than one generic form.

· The first-generation models of, for example, Krugman (1979) focus on

inconsistencies between domestic macroeconomic policies, such as an exchange rate
commitment, and a persistent government budget deficit that eventually must be monetized.
The deficit implies that the government must either deplete assets, such as foreign reserves,
or borrow to finance the imbalance. However, it is infeasible for the government to deplete
reserves or borrow indefinitely. Therefore, without fiscal reforms, the government must
eventually finance the deficit by creating money. Since excess money creation leads to
inflation, it is inconsistent with keeping the exchange rate fixed, and first-generation models,
therefore, predict that the regime inevitably must collapse.

· In second-generation models of currency crises, best represented by Obstfeld (1986,

1994), policymakers weigh the cost and benefits of defending the currency and are willing to
give up an exchange rate target if the costs of doing so exceed the benefits. In these models,
doubts about whether the government is willing to maintain its exchange rate target can lead
to the existence of multiple equilibria, and a speculative currency attack can take place and
succeed even though current policy is not inconsistent with the exchange rate commitment.
This is because the policies implemented to defend a particular exchange rate level, such as
raising domestic interest rates, may also raise the costs of defense by dampening economic
 activity and/or raising bank funding costs. The private sector understands the dilemma facing
the government, and may question the commitment to fixed exchange rate when other
macroeconomic objectives are compromised. In this framework, a speculative attack is more
likely to succeed if higher interest rates exacerbate already weak domestic employment or
banking sector conditions. Consequently, the timing of the attack – and whether it will occur
– cannot be determined, as it is no longer unique.

These different explanations for currency crises are not mutually exclusive. The fundamental
imbalances stressed by first-generation models make a country vulnerable to shifts in investor
sentiment, but once a crisis does occur, the second-generation models help explain its self-
reinforcing features.

· Third-generation models are harder to characterize simply but generally focus on

how distortions in financial markets and banking systems can lead to currency crises.
Different third-generation models offer various mechanisms through which these distortions
may lead to a currency crisis. Some models stress how distortions may emerge in the form of
credit constraints. Aghion et al. (2001), for example, highlight that an initial depreciation of a
currency raises the cost of foreign-currency debt obligations of firms and lowers profits,
which in turn may limit borrowing capacity when credit is constrained. The subsequent fall in
investment and output associated with these borrowing limitations may lower the demand for
domestic currency and trigger a currency crisis.

Other third-generation models highlight how financial liberalization and government

guarantees of private sector liabilities can generate moral hazard and unsustainable fiscal
deficits that can lead to crises. For example, McKinnon and Pill (1995) suggest that financial
liberalization combined with deposit insurance may induce banks to fuel a lending boom
involving both foreign and domestic credit expansion that eventually leads to a banking and
currency crisis. Chang and Velasco emphasize the possibility of self-fulfilling international
liquidity crises in an open economy with unrestricted capital markets in which banks issue
deposits in domestic and foreign assets, but have longer term illiquid investments that cannot
be readily converted into cash in the event of a bank run. Dooley (2000) and Burnside et al.
(2004) argue that implicit or explicit government guarantees to the banking system may give
banks an incentive to take on foreign debt, making the banking system vulnerable to attack.
The fragile banking sector in turn makes the task of defending the peg by hiking domestic
interest rates more difficult and may lead to the eventual collapse of the domestic currency.

Explain using a first generation crisis model why a fixed exchange regime will always collapse.
Answer 12.

To understand how a fixed exchange rate regime will always collapse, we need to understand
the impact of keeping the exchange rate fixed.

· Currency cannot be depreciated

· The increase in supply of domestic currency to be purchased by the central bank

· To keep the exchange rate fixed, the central bank would sell foreign currency in
exchange for domestic currency.

· Reduction in foreign reserves

· Balance of payments deficit

 · Inconsistencies between domestic macroeconomic policies

First Generation Crisis model states that:

• Printing money is inconsistent with keeping the exchange rate fixed (Central
bank of the currency in threat can print currency of their nation only and not of the
pegged currency. Also, the central bank can’t simply print their domestic currency
infinitely just to counter the increasing demand of the pegged currency as that will
result in increase in inflation).

• The fixed exchange rate cannot be maintained once reserves vanish (Foreign
currency reserves are finite and they will run- out if they demand for the foreign
currency exceeds the available level).

• When reserves completely deplete, the fixed exchange rate will be abandoned
(the central bank will move to free market forces and the domestic currency will
devalue)

• A speculative attack will arise as it will be anticipated

• Exchange rate will be floating even before reserves come down to zero

• First-generation models predict that the regime must collapse.

Using 2 Generation crisis model, why a fixed exchange regime will always collapse.
nd

Answer 13.

In the second generation model of crises, the economy has a fixed exchange rate regime.
However, it does not have fundamental problems such as a large fiscal deficit, a large current
account deficit, or high inflation. Then, for no apparent reason, currency traders “attack” the
currency, i.e. they start to sell it in large amounts. How should the authorities react? Their
immediately available weapon of defense is to raise interest rates.

Option 1. Raise interest rates to stop the traders from selling the domestic currency. The high
interest rates motivate traders to keep their money in the domestic currency as it gives them a
higher return. However, the high interest rates put pressure on households and firms that have
borrowed money. If interest rates increase a lot, everyone cuts their purchases and the economy
enters a recession.

Option 2. Keep interest rates unchanged and avoid a recession. In that case, however,
investors keep fleeing and the currency devalues.

Therefore, the choice is recession or devaluation. Put into that situation, many governments
prefer devaluation. Notice that the devaluation happened only because the currency traders
started selling the currency. Otherwise, there would be no problem. Hence, these types of
crises have no warning signs. Something could trigger the sell-off and the devaluation
becomes a self-fulfilling prophecy.

According to 2 Generation model, raising the domestic interest rate would worsen the crisis
nd

situation, what alternative measure does this measure suggest.

Answer 14.
In the second generation model of crises, the economy has a fixed exchange rate regime.
However, it does not have fundamental problems such as a large fiscal deficit, a large current
account deficit, or high inflation. Then, for no apparent reason, currency traders “attack” the
currency, i.e. they start to sell it in large amounts. How should the authorities react? Their
immediately available weapon of defense is to raise interest rates.

Option 1. Raise interest rates to stop the traders from selling the domestic currency. The high
interest rates motivate traders to keep their money in the domestic currency as it gives them a
higher return. However, the high interest rates put pressure on households and firms that have
borrowed money. If interest rates increase a lot, everyone cuts their purchases and the
economy enters a recession.

Option 2.

· No change in the interest rate

· Either recession or Devaluation (multiple outcome)

· Usually governments choose devaluation

· Fixed exchange rate regime will collapse

· Self-fulfilling prophecy (crisis started as traders attacked the currency)

Explain the Impossible Trinity/Trilemma.

Answer 15.

The impossible trinity, also called the Mundell-Fleming trilemma or simply the trilemma,
expresses the limited options available to countries in setting monetary policy. According to
this theory, a country cannot achieve the free flow of capital, a fixed exchange rate and
independent monetary policy simultaneously. By pursuing any two of these options, it
necessarily closes off the third.

According to the trilemma model, a country has three options. It can:

A - Set a fixed exchange rate between its currency and another while allowing capital to flow
freely across its borders,

B - Allow capital to flow freely and set its own monetary policy, or

C - Set its own monetary policy and maintain a fixed exchange rate.
The country cannot, however, fix exchange rates, allow capital to flow freely and maintain
monetary policy sovereignty. For example, Country X links its currency, the X pound, to the
Y franc at a one-to-one ratio. This is effective if both Country X and Country Y's central
banks maintain a policy rate of 3%. But if Country Y raises interest rates to combat rising
inflation, investors would spot an opportunity for arbitrage. X pounds would flood over the
border to buy Y francs and earn the higher interest rate.

Y francs would in effect become worth more than X pounds. Thus, either Country X
abandons the currency peg and allows the X pound to fall, raises its policy rate to match
Country Y's policy rate abandoning monetary policy independence or it sets up capital
controls to keep X pounds in the country.

Real-world examples of these trade-offs include the eurozone where countries have opted for
side A of the triangle: they forfeit monetary policy control to the European Central Bank but
maintain a single currency (in effect a one-to-one peg coupled with free capital flow). The
difficulties of maintaining a monetary union across economies as different as Germany and
Greece have become clear as the latter has repeatedly appeared poised to drop out of the
currency bloc.

Following World War II, the wealthy opted for side C under the Bretton Woods system,
which pegged currencies to the dollar but allowed them to set their own interest rates. Cross-
border capital flows were so small that the system held for a couple of decades – the
exception being Mundell's native Canada, a situation that gave him special insight into the
tensions inherent in the system. Today, most countries allow their currencies to float,
meaning they opt for side B.

The French economist Hélène Rey has argued that the trilemma is not as simple as it appears
since most countries lack monetary policy independence whether or not they have free
exchange rates and capital flows. The reason is the overwhelming influence of the Federal
Reserve.