It is a disruption to financial markets, connected most times with price depreciation of assets, and causes bankruptcy among debtors and financial institutions. This, in turn, extends through financial systems, causing a disturbance in the market’s willingness to provide capital. To understand why financial instability matters to the economy, we would look at the importance of financial stability. It is the confidence and public trust in intermediaries, infrastructure, markets, and the economic system as a whole. Therefore, financial stability is essential to a well-functioning economy.

Causes of financial instability

In recent years, we have observed increased financial crises in different economies, e.g., problems connected with intermediaries and stock market crashes. We will use financial instability to refer to financial crisis cases and troubles of financial institutions for depositors. Our primary focus will be on factors that disrupt and threaten the normal functioning of financial institutions and economies.

Changing prices on assets

At times housing prices on the real estate market fall, they were impacting adverse wealth effects on the homeowners. A fall in their net worth leads to low confidence in intermediaries and low spending. This may result in financial losses for financial institutions. For example, in 2006, the USA real estate market saw its housing bubble burst with a 50% fall in prices. This led to banks losing money due to unpaid mortgage payments.

In 2007, a credit crisis led to a fall in lending money and the 2008 recession. this was caused by the housing bubble burst in 2006.

Global credit markets

Loans given to people with low credit scores in the USA caused many firms to go bankrupt. This led to a remarkable fall in confidence in lending money. This credit crisis affected the economy of the country and led to reduced consumer confidence.

Fluctuations in the stock market

A considerable fall in the stock market may trigger a drop in consumer confidence and a loss of consumer wealth. For example, there was a wall street crash in 1929, which caused a great depression. In the year 2008, the stock market crashed again, causing a recession.

A fall in shares doesn’t need to cause instability. The was a stock market crash in 1987 in the UK, and it did cause any financial instability. But, it was followed by an economic boom. This was due to the countermeasures made by the government. They made cuts to interest rates and income taxes.

However, if the fall in stock prices are brought pandemics, e.g., the coronavirus pandemic that hit the country in march 2020, then a drop in stock shares may intensify.

Global factors

In this age of globalisation, many world economies interdepend with each other. For example, if the USA or chinas economies suffer instability, there would be slow growth globally. In earlier years, all the world’s economies were dependent on the US economy. If its economy experiences a recession, it will affect the whole of the world. This is because thein confidence USA was the biggest imports consumer. However, in current times, countries such as China and India have grown their economies. In 2020 when the covid 19 pandemics hit china, there was a significant deterioration in the manufacturing market.

Varying interest rates

Interest rates are a significant determinant of the inflation rate and may also affect consumer spending. When interest rates are combined with other factors, they may have a significant effect on consumer spending.

Government debt crisis

In occasions of existing government debts to various multilateral institutions or external shareholders, the economy is likely to suffer liquidity shortages. This increases up interest rates on government bond yields. As a result, there will be an increase in the interest rate on the payment for the debt owed by the government. As a result, many governments will reduce the budget deficit, which hurts the economy.

Unexpected events

These are sudden catastrophic events that can make the economy of a country unstable. For example, the outbreak of a deadly disease can cause reduced travelling and hinder many economic activities from taking place. The outbreak of the coronavirus pandemic is an excellent example of events that can cripple the economy. The virus led to the closure of borders and disrupted many economic activities.

Unpredictable leadership

Some leaders may impose laws that may hinder the growth of an economy. In addition, it can cause financial instability. For example, the trade war with China in the USA has led to a decrease in global trade.

How to curb financial instability

There have been many forums on how the central bank can respond to a prolonged downturn in the economy. In the past US recessions, they had tackled in many ways, including federal reserve easing while globally the central bank used the balance sheets thoroughly.

Some economists that unconventional monetary policies may provide a suitable response through negative rates. Rates are held at low levels rather than being justified by innovations, policies, and inflation goals.

Fiscal policy is another approach, and it is observed that in developing economies, chances for an evading crisis are low. With increasing public debts, there is a chance of consumer spending increasing and tax cuts. In many developing countries, the deficits are too high to stabilise. This results in increased unemployment. It is not easy for governments to respond efficiently to the allocated budgets.

Saving banks at the expense of small business owners may not be the best idea since supporting a larger share of the economy would stretch public finances.

Another cause of action is the essential preparedness of multilateral. For example china, institutions like IMF have contributed a more significant role in responding to the financial crises and maintaining the global economy. However, In developing economies, the IMF evolution process needs to continue.

Increase capital requirements for non-bank financial intermediation and financial institutions accepting deposits from the general public and make them be able to profit despite the great financial crisis.

It is also observed that getting rid of liquidity and capital on banks is a safe way of avoiding bankruptcy on many financial institutions. But, on the other hand, liquidity has been observed to cause many cash outflows, and this suffers setbacks in times of financial crisis.

Governments should advocate offering the public consumer literacy regarding financial matters and eliminate the consumer leverage ratio, which is used to quantify debt owed per household income.

A country should concentrate on most of the financial institution governance and their culture.

Conclusion

We have found that financial instability occurs when significant contributors to the financial market become bankrupt, and they are no longer able to pay their creditors. In this state, a financial system is prone to have a financial crisis. We have discussed various ways to mitigate issues of financial instability and their key players.