Week 8 - Assignment Example

Global Imbalances and Developments in the Financial Markets as the main cause of Financial Crisis Financial crisis refers to a situation of excess money demand that forces banks to sell some of its investments to counter the excess demand. Global imbalances refer to deficits in the current account of one country that cancels out equally high surpluses in other countries. In the last two decades, all countries of the world have faced various global imbalances and developments in financial institutions and markets.

The financial markets developments have been as a result of financial deregulation in many countries. Global financial crisis and developments in the financial markets have been the principal cause of the current worlds financial crisis as explained below. All countries in the world faced the global financial crises but to different degrees. Taking a look at the Europe, and also the United States, it is evident that these countries were the epicenter of financial crisis. This is because they depended on the financial sector as their growth engine.

A decade ago, Asia saw a decline its net demand for exports. However in the recent past, Asia has managed its export growth cautiously after its Crisis of a decade ago. Eastern Europe was dependent on large scale imports of capital through banking channels. Eastern Europe was, therefore, suffered from the reversal in capital flows. African and South American economies through the substantial drop in prices of vital commodities and deterioration as concerns their trade. In India, though the financial sector remained strong, they experienced sudden reversals capital flow as they applied the process global de-leveraging.

However, In India, liquidity problems transmission took place using the confidence channel. These Macro imbalances built up as the world experienced a phenomenal increase in global trade. The increase for the last 50 years was from 24 per cent in the year 1960 to 57 per cent in the year 2006. Also, For the whole world taken together, the ratio of assets and liabilities for foreign countries to GDP rose from 45 per cent in the year 1970 to over 300 per cent in the year 2004. These imbalances directly caused the financial crisis.

Ways of Preventing Build up in Global Imbalances Global imbalances are inevitable all over the world due to interdependencies that exist between different countries. However, various methods and mechanisms can be employed to make sure that the imbalances do not reach destabilizing levels (Uzan 2009). These build ups in Global imbalances can be prevented through the following ways. Firstly the governments should use monetary and fiscal policies. On the part of monetary policy, the central banks seek to reduce short-term interest rates to influence the level and pattern of the economic activity in the long-term (Kolb, 2010).

This increases the level of investment. However, the monetary channel of transmission suffers from the time lag and, therefore, the public hardly feels its effect. Since, these imbalances result in fiscal differences, the government should seek to cover these deficits through issuing of high powered money to the economy. However, this poses challenge to the central banks on how to maintain constant liquidity with high inflation expectations. Secondly governments can embark on inflation targeting.

This has borne more fruits than monetary form of targeting especially in India. This method increases transparency, accountability and also enables proper planning by the countries involved. However, it is rigid, hinder growth and may not be applicable in countries that face supply shocks. In conclusion, build ups in global imbalances and financial markets developments are the root causes of financial crisis. Governments should employ various measures to prevent these imbalances from building up to destabilizing levels.

References Kolb, R. W. (2010). Lessons from the Financial Crisis: Causes, Consequences, and our Economic Future. Hoboken: Wiley. Uzan, M. (Ed). (2009). The Macroeconomics of Global Imbalances: European and Asian Perspectives. (1st ed.). New York: Routledge.