Here is a question and answer from the financial sector topic within the A-level Economics syllabus.
This question is an evaluate question - the type of question students tend to struggle with.
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Evaluate the microeconomics and macroeconomic effects of market failure in the financial sector.
(You can use the information provided to help you with this question - background reading at the bottom of the page)
The question asks you to evaluate microeconomic and macroeconomic effects. Therefore, it’s good to divide your plan into 2 sections.
Model Answer Guidance
(Gain access to full model answers here)
Microeconomic effects of financial market failure
Housing bubble - occurs when there’s too much demand in the housing market - houses become overvalued - can lead to negative equity - homeowners losing confidence - leads to high level of defaults - increases in relative poverty
Effect on the bank’s stakeholders
- one stakeholder is the shareholders - stock market - bank risk taking behaviour meant their balance sheets quickly became insolvent - this quickly lowered the price of shares - affected people’s wealth
- another stakeholder is the banks’ workforce - many were laid off, causing more poverty and increased unemployment
- another stakeholder is the taxpayer - banks needed bailing out from the government - taxpayers had to pick up the bill
Another effect on the market is the interest rate - banks were miscalculating their risk (undervaluing it), which led to lower-than-necessary interest rates - this encourages more risk-taking behaviour amongst sub-prime borrowers
Opportunity costs - as mentioned above, taxpayers picked up the bill for bank failures - this meant opportunity costs (that money could have been used on something else)
A shortage of liquidity - less risky people who wanted loans were not able to get access to them due to the credit crunch - these could have been small businesses or first-time house buyers
Unemployment in other industries - the failure of banks caused other industries to lay off workers - alternatively, many labour markets started offering 0-hour contracts which led to a lack of welfare for employees
Macroeconomic effects of financial market failure
Global unemployment - global failure of the banking sector caused lowered business confidence, lack of credit, negative multiplier effect - AD fell - lower derived demand for labour
Government debt increase - bailing out banks - boosting the economy with fiscal policy - debts soared - led to fiscal austerity as new government had to bring in policies to reduce spending in time of recession
Monetary policy - almost became useless - interest rates down to record low, economy still in recession and unemployment still high - interest rates can’t go below 0% - quantitative easing programs had to be launched (printing money) - this is not a good long-term solution
Economic growth - global recession - probably the worst in a century - impacted living standards, relative poverty, unemployment - affected some more than others e.g. industries going out of business or regional divides
Global trade - lowered national income levels meant countries reliant on exports experienced lowered demand
evaluation points
To evaluate points:
- you could talk about short run vs long run effects
- talk about the different groups of people who were affected - who were the winners, who were the losers
- the costs to society depend on the government response to the failure of the banking system e.g. did the government fail or did they do a good job to prevent this happening again
- effects depend on the effectiveness of regulation e.g. microprudential/macroprudential regulation of financial sector
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Learn about the financial sector. Understand and learn more about how the financial market failure. Learn more about systemic risk, market bubbles, externalities, asymmetric information and market rigging. Revise using Mr Banks's A-level economics revision pages at mrbanks.co.uk. Attend our A-level economics revision courses!