This lecture examines the causes of the recent financial crisis and subsequent recession. On the macroeconomic side, the Great Moderation encouraged an overly optimistic assessment of risk. Combined with low interest rates, reflecting both loose monetary policy and relatively high Asian savings rates, that encouraged a build-up of excessive leverage in the banking system. On the microeconomic side, distorted incentives led to a concentration and mispricing of risk. Informational complexities associated with new financial assets and the interconnectedness of financial institutions then resulted in the closure of funding markets and a flight to safety when loan defaults rose unexpectedly. The episode indicates the need to focus on agency and information problems between banks and their funders in addition to those between the banks and their borrowers. It also suggests that the process of financial intermediation should play a more prominent role in macroeconomic models.
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