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Basics of Financial crisis

Updated on April 20, 2016
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IRSHAD CV has been a student in Economics. Now he is doing Masters in Economics. He completed B.A. Economics from the University of Calicut.

Financial crisis is a global phenomenon. It affects all countries.
Financial crisis is a global phenomenon. It affects all countries. | Source

Financial crisis has become a commonly using phrase among people irrespective of their profession, social and economical status and even level of knowledge. What does it mean by financial crisis? Why people are afraid of it? Is it possible to predict financial crisis? I am sure that, there will be series of similar questions for which people are seeking answers. Very recently, the whole world has experienced the financial crisis of 2007-08. It affected almost all countries and various economic agents. Even today, some advanced countries are challenging with it. Why and how financial crisis is happening?

Understanding Financial Crisis

When people think of financial crisis, it is often that, some key signs are coming into the mind. During financial crisis, national output of countries will decline, investment and savings will be lower, and unemployment and market price determination are will be out of control. Generally, financial crisis creates risky conditions in the society. This may sometimes lead to social and political instabilities, questioning of central bank policies and great tough deal with public expenditures. Once, financial crisis happens, the macroeconomic variables will out of control.

In a modern capitalist economy, financial crisis highly reflects on the stock markets and in the volume of investment and savings. In reality, what is happening in the stock markers during prosperity? The investment boom continues until the financial crisis occurs. More clearly, the investor expects high return from the investment. So, he will do efficient portfolio management. Once, his investment get appreciation, the investor will be happy. In almost all the capitalist economies, people invest money and earn high return along boosting with capital accumulation. But, economists are saying that, this accumulation is actually a type of bubble and will break once it reaches at its peak. This same process is happening in capital market or stock market. The investment gain and value appreciation will be limited to certain constraints. Once it reaches at its maximum possible level, the market system will reverse the process and will lead to the so called economic crisis.

Business Cycle and Financial Crisis

Business cycle is also known as trade cycle. It is a model developed by economists to show the aggregate economic activities. There are different versions of business cycles. A simple business cycle curve has a nature of increasing and decreasing trends at different time periods. When the economy experience growth or expansion, the business cycle will move up. In such a case, investment, savings, employment, national output and other economic variables would tend to expand and closer to optimum level. On the other side, during crisis, all these variables become out of control and vulnerable.

Now the question is that, why the economy is experiencing meltdown or crisis? In a market oriented or capitalist economy, there will be higher level of motives among economic agents towards maximization of output and profit. So, during prosperity, firms will produce more not only for domestic demand but also for meeting the demand in the foreign market. When the production process has maximized, and the demands are fulfilled, there will be no further possibility producing the output. Thus companies will force to reduce their production. They will start this by reducing the labor force. Thus unemployment will go up. It will automatically reduce the income and demand of unemployed. This fall in aggregate demand again causes to reduce production, utilization of workers and so on. In fact the reverse process from the peak of economic prosperity to economic degradation is crisis. To revive from crisis, government uses various fiscal policies and sometimes it may counter through legislation.

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The Experience of Predicting Financial Crisis

So far, based on the experience of nations, some economists were predicted financial crisis. Dr. Reghuram Rajan (Governor of Reserve Bank of India) rightly predicted the financial crisis of 2007-08. But predictors and similar agencies are rare. Some other group of economists is arguing that, economics needs more improvement and tools in its analysis. The present tools are not enough to understand what is going on in our economic systems. That is why a mass majority of the economists were failed and still unable to understand the core issues. This argument is valid because the world has experienced crisis at different times. Some parts of the world are still struggling with similar issues like China, Greece etc. Thus economic tools have to be enough for predicting economic meltdowns. Then only, appropriate methods can be followed to counter these evils.

Indeed, there are things which each individual must be aware of. As a social being, the understanding of some fundamental concepts may help the people to get an aloof from mass economic destructions. Two important points are mentioned below.

  • Financial Literacy

Individuals must be aware of basic financial related concepts. People should get basic education of financial literacy. It will help the people to avoid risky conditions in their financial matters. Efficient portfolio management is one of the components of financial literacy. Thus financial literacy should be a part of our educational system. Then, the optimum utilization of financial resources can be ensured by minimizing risk.

  • Illusion of Money

Money illusion is a reality that everybody experiencing in our life. Simply it is a fake raise in income of people. Suppose, the income of people doubled, sure they will be happy. But this raise in income may be because of the hike in general price level. The net effect will be zero. That means, people can’t do anything with the increased income, instead they requires to pay the amount on consumption due to the increase in general price level. In certain cases, people make mistakes. The increase in income may spend for additional consumption rather than saving it. This tendency of further consumption may again lead the economy to have a condition of higher price level. In fact, understanding the cause and effect relationship of economic variables will be a great wealth for escaping from crisis.

Concluding Remarks

Financial crisis has become an uncertain one and it is capable of threatening the social system. The recurrent nature of financial crisis is one of the great symptoms of poor sustainability of our social systems. This issue can be controlled through promoting financial education to individuals. Further, the government must control the economic system to avoid risks and regulate the economic agents who are doing unhealthy economic activities.

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    • Matt Easterbrook5 profile image

      Matthew A Easterbrook 18 months ago from Oregon

      Yes, ICV unfortunately in schools and higher education they only teach a tip of the ice berg in this area of study.

    • icv profile image
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      IRSHAD CV 18 months ago from India, Kerala

      Thanks Matt Easterbrook5 for reading and leaving a comment here. Financial literacy is one of the important lessons which should be included in our academic curricula.

    • Matt Easterbrook5 profile image

      Matthew A Easterbrook 18 months ago from Oregon

      Yes, great article. I agree we all need to have financial literacy. Who is best at managing your own money? Well it should be the individual. I would recommend that individuals also use companies like T.Rowe Price, Fidelity, Vanguard for their retirement- financial planning. These are all Federally insured companies that also have good customer service and will assist you with the best retirement program etc..

    • icv profile image
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      IRSHAD CV 18 months ago from India, Kerala

      Thanks to both Sneha Sunny and always exploring for reading and leaving your responds.

      We have to strengthen our economies to resist crisis at the global level. To do so, we have improve our knowledge of finance and behavioral sciences.

    • always exploring profile image

      Ruby Jean Fuller 18 months ago from Southern Illinois

      Interesting topic and information. Let's hope we're not headed for another financial crisis....

    • Sneha Sunny profile image

      Sneha Sunny 18 months ago from India

      Useful hub! :)