4201 Assignment 2 Essay

Akela Etienne-Forbes
Monetary Economics
Writing Assignment 2

A Synopsis of the Minsky Model As Presented in
‘Chapter 2 -- The Anatomy of a Typical Crisis’ in Manias, Panics and Crashes - A History of Financial Crises

The term “Financial Crisis” is a situation in which the value of financial institutions or assets drops rapidly. Such a crisis is met with panic in which investors may sell off assets or withdraw from savings accounts with the expectation that the value of those assets will drop if they remain at a financial institution. Hyman Minsky is an American economist who attempted to provide an understanding and explanation of the characteristics of financial crises, which he attributed to swings in a potentially fragile financial system. Minsky developed a model which help explains the financial crisis in The United Stated, Britain and other market economics. This model of a crisis covers the boom and subsequent bust and centers on the episodic nature of the mania and the subsequent events (p.26). Minsky believed that increases in the supply of credit in good economic times and the subsequent decline in the supply led to fragility in financial arrangements and increased the likelihood of a crisis (p.27). His model fused many ideas already publicize by John Stuart Mill, Alfred Marshall, Knut Wicksell and Irving Fisher, who focused on the variability in the supply of credit. Minsky through this model identified five states in a typical credit cycle-displacement, then boom that lead to a state of Euphoria, which eventually leads to Panic. He argued that the financial system in a market economy is unstable, fragile, and prone to crises (P.18) which makes it very vulnerable. Minsky suggested that the events that lead to a crisis start with “displacement’ or innovation, some erogenous shock to the macroeconomic system. ‘Displacement’ consists of events that change the situation, extend the horizon, and alter expectations such as an invention, war or a change in economic policies. If the shock was sufficiently large and pervasive, the economic outlook and anticipated profit opportunities would improve in at least one important sector of the economy and business firm and individuals would borrow to take advantage of the increase in the anticipated profits in this particular sector. In such cases, otherwise rational expectations of some investors fail to recognize the strength of similar response by others (p.48). When there appears to be a shortage of physicists or mathematicians or school teachers many young people enter graduate school to prepare for one of these professions; by the time they have finished their studies, there may be an ‘excess supply’ of individuals trained for careers in this field. After the belated surge in supply, job opportunities suddenly become scarce. The price increase sharply in response to the initial surge in demand and then declines even more rapidly as the new supply becomes available (p.48). Following displacement price slowly begins to rise but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. The boom in the Minsky Model is fueled by the expansion of credit. The shock varies from one speculative boom to another and according to Minsky if the shock was large enough and pervasive, the economic outlook and the anticipated profit opportunities would improve in at least one important sector of the economy. Assume an increase in demand for goods and services. Eventually the increase in demand presses against the productive capacity, prices increase and the more rapid increase in profits attracts both more investment and more firms. Positive feedback develops as the increase in investment leads to increases in the growth rate that in turn induces additional investment (p.29) Minsky noted that “euphoria” might develop at this stage. Investors buy goods

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