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What policies are most effective in mitigating the effects of financial crises?

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Financial crises can have devastating effects on the economy, society, and the environment. They can cause recessions, unemployment, inequality, poverty, social unrest, and environmental degradation. How can governments and central banks prevent or mitigate these negative impacts? What policies are most effective in addressing the root causes and the symptoms of financial crises? In this article, you will learn about some of the main types of financial crises and the policy responses that can help to stabilize the financial system, support the real economy, and protect the vulnerable.

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1 Types of financial crises

Financial crises can take different forms depending on the source and the transmission of the shocks. Some of the most common types are banking crises, sovereign debt crises, currency crises, and asset price bubbles. Banking crises occur when banks face a sudden loss of confidence from depositors or creditors, leading to a run or a collapse. Sovereign debt crises happen when governments cannot repay or refinance their debts, resulting in default or restructuring. Currency crises arise when a fixed or pegged exchange rate becomes unsustainable, forcing a devaluation or a collapse. Asset price bubbles occur when the prices of assets, such as stocks, real estate, or commodities, rise far above their fundamental values, creating a risk of a sharp correction or a burst.

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Aditi Mittal, CFE

Empowering Clients in Mitigating Reputational Risks | Pre-deal Due Diligence | Founder @Fullcircle Risk Consulting | Investment Advisor | Deal Scout @Epic Angels
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It depends on the type of crisis. There are some textbook policy paths that are followed during specific events like recession or debt crisis. For instance, during high inflation, central banks maneuver with monetary policies. During recessionary times, fiscal policies will be more pronounced, with the governments injecting liquidity to stimulate the economy. In a debt crisis, it will be a combination of debt restructuring and reforms depending on the nature of the crisis.

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2 Policy objectives

The main objectives of policy interventions during financial crises are to restore financial stability, to stimulate economic activity, and to prevent or alleviate social hardship. Financial stability means that the financial system can function normally, providing credit, liquidity, and payment services to the economy. Economic activity means that the output, income, and employment levels can recover from the downturn and resume growth. Social hardship means that the welfare and living standards of the population, especially the poor and the vulnerable, can be protected or improved.

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3 Policy instruments

To achieve these objectives, policymakers have a range of instruments at their disposal. These include monetary policy, fiscal policy, financial regulation, and social policy. Monetary policy involves adjusting the interest rate, the money supply, or the exchange rate to influence the cost and availability of money in the economy. Fiscal policy involves changing the government spending, taxation, or borrowing to influence the aggregate demand and supply in the economy. Financial regulation involves setting and enforcing rules and standards for the financial institutions and markets to ensure their soundness and efficiency. Social policy involves designing and implementing programs and transfers to support the income, health, education, and social protection of the population.

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4 Policy trade-offs

However, policymakers also face trade-offs and constraints when choosing and implementing these instruments. For example, lowering the interest rate or increasing the money supply can stimulate the economy, but it can also create inflationary pressures or weaken the currency. Increasing the government spending or cutting the taxes can boost the aggregate demand, but it can also increase the budget deficit or the public debt. Tightening the financial regulation can enhance the financial stability, but it can also reduce the financial innovation or inclusion. Expanding the social policy can improve the social welfare, but it can also raise the fiscal burden or the dependency.

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Mathew Job

Ex-Temporary Civil Servant at Australian Civil Service
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The last global crisis occurred relatively in one country with international reach, the United States of America. In that country two major banks were bailed out with one too big to save Lehman Brothers. In 2009. The effects of the banking crisis affected the British and American Economies both of which went into recession. The Australian Government Deposit Guarantee and a variety of a better off Christmas stimulus measures shielded the Australian Economy from the recession. Along with very low interest rates. It gas taken over a decade for the inflationary effects of the stimulus packages to make effect on Australian monetary and fiscal policy setting along with a energy price crisis.

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5 Policy coordination

Therefore, policymakers need to coordinate their actions and balance their effects across different instruments, objectives, sectors, and time horizons. For example, they need to coordinate the monetary and fiscal policies to ensure that they are consistent and complementary in supporting the economy. They need to balance the financial stability and economic activity objectives to avoid excessive risk-taking or excessive austerity. They need to consider the impact of their policies on different sectors, such as households, businesses, and banks, and address their specific needs and challenges. They need to take into account the short-term and long-term effects of their policies and avoid creating moral hazard or unsustainable imbalances.

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6 Policy evaluation

Finally, policymakers need to evaluate the effectiveness and efficiency of their policies and learn from their successes and failures. They need to monitor and measure the outcomes and impacts of their policies on the financial system, the economy, and the society. They need to compare and contrast their policies with those of other countries or regions that faced similar or different crises. They need to identify and analyze the factors and conditions that influenced the performance and the results of their policies. They need to draw and apply the lessons and best practices from their experiences and improve their policy design and implementation in the future.

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7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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What policies are most effective in mitigating the effects of financial crises?

1

2

3

4

5

6

7

1 Types of financial crises

2 Policy objectives

3 Policy instruments

4 Policy trade-offs

5 Policy coordination

6 Policy evaluation

7 Here’s what else to consider

Economics

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What policies are most effective in mitigating the effects of financial crises?

1

2

3

4

5

6

7

1 Types of financial crises

2 Policy objectives

3 Policy instruments

4 Policy trade-offs

5 Policy coordination

6 Policy evaluation

7 Here’s what else to consider

Economics

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