Financial Market Failure | A-Level Economics Model Essay

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Evaluate the likely microeconomic and macroeconomic effects of market failure in the financial sector (25 marks)

Microeconomics is about firms, individuals and particular markets in an economy, whereas macroeconomics is the study of the entire economy e.g. the UK economy. The four main macroeconomic objectives are price stability, low unemployment, economic growth and a balance of payments on the current account. Market failure is when there is a misallocation of resources, and there are different causes of this in financial markets, such as bank runs and systemic risk.

Financial market failure, such as the global financial crisis from 2007, is initially caused by

risky lending (subprime mortgages)

price bubble

price crash

bank run

insolvency (bankruptcy)

systemic risk (interlinkages causing lender of last resort to step in)

negative externalities (taxpayer) THE MICROECONOMIC EFFECT

The main microeconomic effect of financial market failure is negative externalities. This is the cost to a third party from an economic transaction. In this case, over-consumption of certain financial goods or services lead to a negative impact on third parties, such as the Bank of England and the taxpayer. This is caused by lending from high street banks to risky customers. This may have been caused by imperfect information, for example with banks incorrectly knowing a customer's risk profile or by banks greedily choosing to ignore a customer's risk and passing on the risk to

When there is financial market failure, the Bank of England must act as the lender of last resort. They should bail out banks who are at risk of going bankrupt. This is to prevent the failure spreading across the economy, as financial markets have many links. This would alarm the economy and this would cause aggregate demand (AD) to fall in the UK economy. AD is the total planned spending in the economy which is C + I + G + X-M, and because confidence falls and uncertainty rises, C which is consumer spending, also falls. This causes AD to shift to the left.

AD LEFT DIAGRAM

Price level falls from PL1 to PL2.

Real GDP and employment fall from Y1 to Y2.

Macro: COPY THE EFFECTS OF A RECESSION (expand on WHY THIS IS EVEN BAD)

• high unemployment
  • low disposable incomes
  • further fall in AD
  • fall in confidence
• deflation
  • fear they will lose job
  • prices to fall.
  • delay spending
  • prices fall even more
• EVALUATION
• policies are needed to resolve this; fiscal policy (boost AD)
• BoE were the lender of last resort, rules (reserve ratios), FCA