The financial sector and crises - Basic mechanisms - Asset price bubbles

6 important questions on The financial sector and crises - Basic mechanisms - Asset price bubbles

What does the price dynamic equation show?

The relationship between the price this period and the next period.

Describe the price dynamic processes in different kinds of markets

Figure 6.6
The normal response to a price increase in a situation of excess supply is a fall in the price. In the tulip bulb case, the initial price rise leads the demand curve to shift upwards.

Describe the impact of changes in price expectations in a market with an S-shaped PDE curve

Figure 6.7
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Describe the mechanics of the financial accelerator

1. The credit constraints facing a household depend on the value of the collateral it has. The market price of the house establishes its value.
2. A positive shock to house prices relaxes credit constraints.
3. Households borrow more.
4. Some of this borrowing is used for consumption and some is used to buy more housing. This shifts the IS curve.
5. The increased demand for housing, pushes the price up further and the financial accelerator process begins at step 1.

Why is the financial accelerator a positive feedback process?

On the basis of an initial exogenous rise in the price of the asset, a key constraint limiting the household's desired spending is relaxed.

What are the effects of relaxation of credit constraints?

1. It amplifies the business cycle because it stimulates spending by previously credit-constrained people. This shifts the IS curve to the right.
2. It feeds back to push house prices up further.

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