Financial Accelerator - Financial Accelerator Mechanism

Financial Accelerator Mechanism

The link between the real economy and financial markets stems from firms’ need for external finance to engage in investment opportunities. Firms’ ability to borrow depends essentially on the market value of their net worth. The reason for this is the familiar story of asymmetric information between lenders and borrowers. Lenders are likely to have little information about the reliability of any given borrower. As such, they usually require borrowers to set forth their ability to repay, often in the form of collateralized assets. It follows that a fall in asset prices deteriorates the balance sheets of the firms and their net worth. The resulting deterioration of their ability to borrow has a negative impact on their investment. Decreased economic activity further cuts the asset prices down, which leads to a feedback cycle of falling asset prices, deteriorating balance sheets, tightening financing conditions and declining economic activity. This vicious cycle is called a financial accelerator. It is a financial feedback loop or a loan/credit cycle, which, starting from a small change in financial markets, is, in principle, able to produce a large change in economic conditions. Read more: http://www.investopedia.com/terms/f/financial-accelerator.asp#ixzz2KdGqitbZ