In the same manner that a liquidity trap leads to deflation, a credit crunch is also conducive to deflation as banks are unwilling to lend

A credit crunch is an economic scenario in which banks have tightened lending requirements and, for the most part, do not lend

let the market decide where to spend and invest by placing money directly in the hands of consumers.

One way of getting them to do so is through fiscal policy. Governments can give money directly to consumers through reductions in tax rates, issuances of tax rebates, and public spending.

Higher interest rates contributed to the end of rising land prices, but they also pushed the overall economy into a downward spiral.

monetary policy was stop-and-go; concerned about rising prices called inflation and soaring asset prices.

Uncovered interest rate parity (UIP)

The credit crunch of 2007-08 was driven by a sharp rise in defaults on sub-prime mortgages. These mortgages were mainly in America but the resulting shortage of funds spread throughout the rest of the world.

Sudden increase in interest rates (e.g. in 1992, UK government increased rates to 15%)

Credit rating agencies make mistakes in allowing speculative and Ponzi borrowing.

Regulatory capture.

Great Moderation

Economic stability itself breads instability.

In a speech delivered in 2004, Bernanke hypothesized three potential causes for the Great Moderation: structural change in the economy, improved economic policies, and good luck

From the 1960s Vietnam War inflation to the collapse of Bretton Woods to the stagflationary recessions of the 1970s to the era of volatile interest rates and inflation amid a double-dip recession in the early 1980s

mid-1980s to the financial crisis in 2007

During this period, the standard deviation of quarterly real gross domestic product (GDP) declined by half and the standard deviation of inflation declined by two-thirds,

Because debts can be seen as somebody else's problem, we don't address the issue with as much urgency. What we need is for our decisions to take more consideration of policy lags and future costs and benefits.

Policy tools such as tax cuts or interest rate reductions help an incumbent politician brag about a stimulated economy, just before an election. 

The manipulation of interest rates helps to illustrate policy lags. Lowering interest rates will mean more accessible funds for businesses to grow and for governments to borrow. The objective is to increase GDP. However, the fact that borrowing is made cheaper now doesn't mean that businesses immediately start borrowing. And then there's the time it takes between businesses investing the money and growth occurring.  Take a reverse situation where policymakers decide to raise the interest rate. One of the reasons for this decision can be to reduce inflation, and the idea is to slow business activity by making loans more expensive. But again, businesses do not react immediately - they have contracts and spending plans that can't automatically change on the day of an interest rate announcement. 

Brender and Drazen (2005) offer another interpretation: the finding of a political budget cycle in a large cross-section of countries is driven by the experience of ‘‘new democracies’’ — most of which are developing or transition countries — where fiscal manipulation by the incumbent government succeeds politically because voters are inexperienced with elections. Once these countries are removed from the larger sample, the political fiscal cycle disappears.

Automatic stabilizers include unemployment insurance, food stamps, and the personal and corporate income tax.

The lower level of aggregate demand and higher unemployment will tend to pull down personal incomes and corporate profits, which would tend to reduce consumer and investment spending, further cutting aggregate demand and GDP. Consider, though, the effects of automatic stabilizers. As individuals are laid-off, they qualify for unemployment compensation, food stamps and other welfare programs. Additionally, since their income has fallen, so have their tax liabilities. All of these things serve to buoy aggregate demand and prevent it from falling as far as it otherwise would. Thus, recessions are somewhat milder.

For example if at home interest rate is 1%1%1\%, world interest rate is 5%5%5\% and central bank wants to fix exchange rate between two currencies at parity so one home dollar is equal to 1 foreign dollar 1𝐻=1𝐹1H=1F1H=1F, then anyone who has any capital would try to move it to the foreign country. First that capital flight would be disastrously in itself, but then when people move capital abroad they have to go through forex market and this will put pressure on the exchange rate to depreciate, only way how to prevent depreciation and keep exchange rate fixed is for central bank to sell its foreign currency reserves. If the central bank has a lot of foreign currency reserves this can be sustained for quite some time especially if the interest rate abroad is not too different from the one at home, but eventually there will be an end point when the reserves runt out and then having all three policies will be impossible.

In addition, actually what even more, empirical evidence provided by Aizenman (2010) shows that, thanks to globalization, economies actually became even more exposed to potential capital flight (since in globalized world there are less non-governmental impediments to capital flow), so if anything recent empirical evidence shows the trilemma is now even more biding than in the past.

impossible trinity

Economists Michael C. Burda and Charles Wyplosz provide an illustration of what can happen if a nation tries to pursue all three goals at once.

capital controls

Harvard economist Dani Rodrik advocates the use of the third option (c) in his book The Globalization Paradox, emphasising that world GDP grew fastest during the Bretton Woods era when capital controls were accepted in mainstream economics. Rodrik also argues that the expansion of financial globalization and the free movement of capital flows are the reason why economic crises have become more frequent in both developing and advanced economies

Currently, Eurozone members have chosen the second option (b) after the introduction of the euro.

The devaluation came after threeyears during which Mexico had followed anexchange rate policy of maintaining the peso withina well-defined band against the U.S. dollar. During1994, this policy had come under pressure as theMexican current account deficit rose to about $29 bil-lion (8 percent of Mexican gross domestic product),Mexico’s international reserves declined about two-thirds, and the government of Mexico issued morethan $25 billion of peso-denominated short-term debtwhose face value was indexed to the U.S. dollar. Thedevaluation on December 20 failed to stabilize pesofinancial markets; two days later, the Mexicanauthorities were forced to allow the peso to floatfreely, and its external value plummeted.

Thus, devaluation caused capital outflows and to counter it the central bank had to run a contractionary monetary policy. An attempt to maintain a fixed exchange rate in Mexico, did not succeed with both capital mobility and an independent monetary policy.

skeptical and started worrying about and expecting further devaluations

Both domestic and international economic factors, along with political forces helped precipitate the crisis

The falling peso was eventually propped up by a $50-billion bailout package coordinated by then U.S. President Bill Clinton and administered by the International Monetary Fund (IMF)

The 1994 Mexican currency crisis was a sudden devaluation of the Mexican peso

Speculators recognized an overvalued peso and capital began flowing out of Mexico to the United States, increasing downward market pressure on the peso.

central bank intervened in the foreign exchange markets to maintain the Mexican peso's peg to the U.S. dollar by issuing dollar-denominated public debt to buy pesos.

capital flight.

Mexican peso crisis was a currency crisis sparked by the Mexican government's sudden devaluation of the peso against the U.S. dollar in December 1994

The Aftermath

the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.

Which doesn't mean that there won't be another financial crisis in the future. Bubbles have occurred periodically at least since the 1630s Dutch Tulip Bubble.

Greece defaulted on its international debts.

First, low-interest rates and low lending standards fueled a housing price bubble and encouraged millions to borrow beyond their means to buy homes they couldn't afford.The banks and subprime lenders kept up the pace by selling their mortgages on the secondary market in order to free up money to grant more mortgages.The financial firms that bought those mortgages repackaged them into bundles, or "tranches," and resold them to investors as mortgage-backed securities. When mortgage defaults began rolling in, the last buyers found themselves holding worthless paper.

The passage of the bailout package stabilized the stock markets, which hit bottom in March 2009 and then embarked on the longest bull market in its history.

indignation was widespread

collapse of the venerable Wall Street bank Lehman Brothers in September marked the largest bankruptcy in U.S. history

March, global investment bank Bear Stearns, a pillar of Wall Street that dated to 1923, collapsed and was acquired by JPMorgan Chase for pennies on the dollar

August 2007: The Dominoes Start to Fall

During February and March, more than 25 subprime lenders went under

collateralized debt obligations (CDOs)

Eventually, interest rates started to rise and homeownership reached a saturation point

Federal Reserve lowered the federal funds rate from 6.5% in May 20001 to 1% in June 2003.2Federal Reserve. "Open Market Operations." Accessed Aug. 22, 2020. The aim was to boost the economy by making money available to businesses and consumers at bargain rates.

dot-com bubble

We estimated that each 10% increase in the number of unemployed men was significantly associated with a 1.4% (0.5% to 2.3%) increase in male suicides.

In early 2010, the developments were reflected in rising spreads on sovereign bond yields between the affected peripheral member states

Several of these countries, including Greece, Portugal, and Ireland had their sovereign debt downgraded to junk status by international credit rating agencies

With increasing fear of excessive sovereign debt, lenders demanded higher interest rates from Eurozone states in 2010,

Seventeen Eurozone countries voted to create the EFSF in 2010,

Also in 2009, Greece revealed that its previous government had grossly underreported its budget deficit, signifying a violation of EU policy and spurring fears of a euro collapse via political and financial contagion.

The debt crisis began in 2008 with the collapse of Iceland's banking system, then spread primarily to Portugal, Italy, Ireland, Greece, and Spain in 2009