Role of Banking in economic crisis

Subject : Economy

Context:

The nobel prize for economics this year highlighted how failure of banks can aggravate a conventional economic crisis.

Details:

Ben S Bernanke’s work:

It suggested bank failures during the depression sustained and aggravated the depressing conditions for a longer time, covering 1929-1933, in the US.
Failure of banks has the potential to affect the medium-term prospects of economic prosperity.

Diamond and Dybvig work:

Banks play a critical role in mobilisation of savings and converting the savings in an economy into productive investments. Thus, eliminates the deficiency of demand due to deficient investment.
Banks help in addressing the mismatches in the preferences of the savers and borrowers.
- The borrowers prefer longer term to maturity for their loans, while the savers require the option to immediately draw upon their savings. This leads to maturity mismatch.
- In the absence of banks, it is impossible for the borrower to approach a large number of savers with little acquaintances and pool the loan amount. This leads to size mismatch.
Banks play a critical role in resolving the conflict, and provide options for both the savers and borrowers as per their preferences.
Banks enable mobilisation of savings and promotion of capital formation, which help in achieving and sustaining economic growth by addressing.

The Keynesian explanation on the causes of the Great Depression:

It was given by John Maynard Keynes.
It emphasises on the role of deficient aggregate demand in causing underemployment equilibrium or depression .
- Aggregated demand means the total demand for final goods and services in an economy.
- It is the total (final) expenditure of all the units of the economy, i.e., households, firms, government, and the rest of the world.
It is suggested that inadequate investment and consumption expenditure driven by the animal spirits of pessimism led to the Great Depression of early 1930s.
The ‘animal spirit’ is a term coined by the famous British economist, John Maynard Keynes, to describe how people arrive at financial decisions, including buying and selling securities, in times of economic stress or uncertainty.
- Animal spirits describe the psychological and emotional factors that drive investors to take action when faced with high levels of volatility in the economy. There is no logical basis for optimism or pessimism of investors.