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What Happens to the Economy during a Financial Crisis?

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  • Written By: K. Kinsella
  • Edited By: Allegra J. Lingo
  • Last Modified Date: 26 August 2014
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A financial crisis occurs when financial markets experience sudden and severe losses, or when investors lose confidence in the financial sector or the economy as a whole. In the economy during a financial crisis, people often have to contend with either inflation or deflation. Lending normally becomes more restrictive, and this contributes to rising unemployment. A general weakening of the economy during a financial crisis can even lead to lead to political instability.

Typically, banks are at the center of a financial crisis because consumers and businesses rely heavily on banks for credit to cover short-term expenses, while savers rely on income from bank deposits to generate income for retirement years. A financial crisis often begins when a bank experiences high numbers of loan defaults as a result of the economy slowing down after a period of rapid growth. Banks curtail new lending to reduce further losses, which means businesses cannot obtain loans needed to finance product development and company expansion. Businesses stop hiring because expansion plans have to be put on hold, cut existing jobs to save money, and attempt to build up cash reserves that can offset the loss of available credit.

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Banks react to the effect of unemployment on the economy during a financial crisis by curtailing consumer lending because rising unemployment usually leads to higher loan default rates. When home buyers become scarce, home owners attempting to sell their homes begin to lower their asking price, and this leads to deflation as prices in general start to fall. Falling prices result in a slowdown in production because people have surplus cash, but the slow down in production often leads to increased unemployment. In a deflationary economy during a financial crisis, savers have increased spending power but due to high unemployment, increasing numbers of people have no income.

An economy during a financial crisis can also experience rapid inflation as investors lose confidence in the government and its ability to cover its debt obligations by raising taxes. Investors demand higher returns on government bonds, and this drives up interest rates on other kinds of investments as well as commodities. Rising prices mean that consumers have less spending power and spend a higher percentage of their income on basic needs, such as food and housing, rather than on luxury items.

Sometimes, a financial crisis can impact the entire world because national economies are intertwined due to the import and export of goods. Nations lacking liquidity reduce imports, which means other trading partners lose income and have to reduce spending. A financial crisis can have a domino effect in a free market economy, and only countries with isolationist economic policies avoid the damaging effects of a global economic crisis.

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Discuss this Article

bluedolphin
Post 3

I completely agree with the domino effect comparison about financial crises and the economy. When banks fail, when the stock market loses investment or when the currency loses value, lots of other problems follow. And it all happens very quickly.

For example, during the 2008 American financial crisis, several major banks failed. As a result other banks stopped lending. It also affected real estate and people couldn't pay their mortgage. A lot of people lost their homes. Many other issues followed like the devaluing of the dollar, unemployment, etc.

An since the American economy is so important for the global market, our crisis quickly turned into a global financial crisis. Once something major happens, everything else seems to follow and it takes a long time and a lot of smart decisions to recover.

SteamLouis
Post 2

@fBoyle-- The Asian financial crisis started with Thailand. Thailand was basically bankrupt and had a lot of debt. When the Thai currency collapsed, it started a serious crisis that affected other countries in the region.

The other currencies in Southeast Asia started to fall, their stocks lost value and debts increased. What happened as a result was that economies slowed down and stopped growing. No one wants to invest in an economy that has a low value and instability. So when investments disappeared, these countries had to borrow money from the IMF and other organizations to re-stabilize their currency and economy.

The effects of a financial crisis on the economy of a country is very bad. It causes a domino effect of negative consequences.

fBoyle
Post 1

What was the result of the economic crisis in Asia in the late 90s? I'm writing a paper on it and I need to learn about the consequences of the crisis in Asian countries. Can anyone help?

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