Banking crisis → Inflation: chain of analysis

ChainWhat it assumes · how to break it

Start

Banks suffer large losses on mortgage-related loans and securities as house prices fall, as in the 2007–08 global financial crisis, and begin to doubt each other's solvency.

As a result, banks stop lending to each other in the interbank market because they cannot tell which banks hold the bad assets, so funding costs rise and credit dries up.
credit crunch · asymmetric information

Assumes: Banks cannot judge each other's exposure to bad loans.

But: If the central bank acts as lender of last resort and supplies liquidity freely, banks can fund themselves without relying on each other.

This means banks with depleted capital tighten lending to firms and households, charging higher rates and demanding larger deposits on mortgages.
credit rationing · capital adequacy

Assumes: Banks rebuild capital by shrinking their lending.

But: If the government injects capital, as the UK did with RBS and Lloyds in 2008, banks need not cut lending as much to restore their capital ratios.

Consequently, investment falls because firms cannot finance projects, and consumption falls as households lose access to credit and house prices fall.
investment · consumption · negative wealth effect

Assumes: Firms and households depend on bank credit to spend.

But: Large firms can borrow directly through bond markets or use retained profits, and many households have little debt, so much spending does not depend on bank credit.

Therefore, aggregate demand falls and a negative output gap opens, leaving firms with spare capacity and weaker sales.
AD · negative output gap

Assumes: The fall in AD is large.

But: If policy makers cut interest rates and use QE quickly, the fall in AD can be limited.

As a result, firms raise prices more slowly or cut them to win customers, and workers accept smaller pay rises, so demand-pull inflation falls.
demand-pull inflation · disinflation

Best link to attack
Assumes: Weak demand is the main force on prices.

But: Cost-push pressure can raise inflation anyway: UK CPI inflation rose well above the 2% target in 2008 and in 2011 as commodity prices rose and the pound fell.

Consequently, if prices start to fall, households may delay purchases in expectation of lower prices, cutting AD further and risking a deflationary spiral.
deflation · expectations

Assumes: Expectations of falling prices take hold.

But: If the central bank's inflation target is credible, expectations stay anchored near the target and a spiral is unlikely.

End

Inflation falls as weak demand opens a negative output gap, with a risk of deflation if the downturn is deep.

Evaluation chainattacks link 5 · Assumptions

E1However, the fall in inflation depends on weak demand being the main force on prices at the time.
E2When the currency depreciates and commodity prices rise, import prices and firms' costs go up even while demand is weak.
E3As a result, cost-push inflation can keep the overall rate high, as in the UK after 2008 when CPI inflation rose above target despite the recession.
E4So a banking crisis lowers inflation by less than the fall in demand alone suggests, and the effect depends on the exchange rate and world prices.

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Questions this answers

Assess the likely impact of a banking crisis on the rate of inflation.
Evaluate why inflation stayed above target in the UK for periods after the financial crisis.
Discuss the risks of deflation following a financial crisis.

Diagram

AD/AS: AD shifts left, so the price level is lower than it would otherwise be and real GDP falls. To show cost-push pressure, add SRAS shifting left.

Reverse and related

Credit boom → AD rises and demand-pull inflation rises.

Questions this answers

Diagram

Reverse and related

GCSE version