How Financial Shock Transmission Affects the Real Economy
Financial shocks are primarily of two types-positive and negative. Positive financial shocks result from taxes or other direct tax payments. These transfers result in price changes as supply exceeds demand, causing a rise in prices above the equilibrium level. Conversely, negative financial shocks are price changes below the equilibrium level, causing a drop in prices above the equilibrium level. Financial market experts use the concept of zero rates of interest to express these effects on the economy.
These zero rates of interest transmitted by the credit crisis to the economy are important forces shaping the economy. Credit conditions in the financial market facilitate financial risks for businesses and households. They also lead to inefficient allocation of capital in business decisions. This means that savings and investment decisions are not made based on real-time conditions in the economy but on estimates of future cash flows at current prices.
Since cash flows are affected by unexpected changes in the credit market, it can have a significant impact on the overall economy. The sudden contraction of financial institutions or a financial market crisis, for instance, can cause interruptions in credit supply and have a significant adverse effect on economic activity. This type of event can temporarily reduce the level of bank lending to businesses. A reduction in business credit, for instance, may prevent business borrowers from making purchases or advances, thus reducing their capacity to absorb shocks in the form of increased unemployment.
The effects of shocks to the economy can also occur due to changes in the political climate. Political uncertainty is a risk that increases the volatility of financial markets. Uncertainty results in uncertainty, which heightens the risks to the financial sector and the economy overall. The uncertainty of the political outlook increases fiscal policy uncertainty, leading to an increase in fiscal policy uncertainty. The imbalance between supply and demand, for instance, can lead to a fall in output in the face of lower orders from customers, and this can have a negative impact on the economy.
One important concept to understand is that of price stability. Although there might be periods of time when the overall financial situation is stable, short-term fluctuations can affect output and cost in surprising ways. Thus, short-term disturbances can affect the economy. The key to stabilizing the economy is a sound long-term fiscal policy. A flexible fiscal policy that is able to provide fiscal stimulus in the face of external shocks is essential in a modern economy.
How financial shocks transmit to the real economy depends largely on how the economy reacts to the shocks. When the financial institutions experience shocks to their ability to fund, for example, they will have to cut back on their lending or take other steps that can lead to short-term shocks to the economy. This can result in more severe downturns in the market. However, the ability of financial institutions to retain and restart lending should be considered in any analysis of how the economy reacts to financial market shocks.