Global Financial Instability: Framework, Events, Issues

Abstract

n the last five years, the global economy has experienced severe bouts of financial instability that have had devastating impacts on crisis countries.Some examples of the impact on GDP are given in Table 1.In Mexico, GDP growth fell from above 4 percent in 1994 before the crisis to Ϫ6 percent in 1995.In Thailand, Malaysia, South Korea and Indonesia, GDP growth fell from above 5 percent in 1996 before the crisis to below Ϫ5 percent in 1998.These swings of over 10 percent in rates of GDP growth are of the same order of magnitude as what occurred in the United States during the Great Depression.Two of the key questions facing policymakers today are how to reduce the risk of global financial instability and how to cope with it when it occurs.This paper starts by defining financial instability and then showing how it harms economic activity.It then uses this framework to describe what happened during the recent financial crises in Mexico and east Asia.The paper ends by raising several key policy issues; not coincidentally, these issues are addressed in the remaining papers in the symposium. What Is Financial Instability?Financial markets perform the essential function of channeling funds to those individuals or firms that have productive investment opportunities.If the financial system does not perform this role well, then the economy cannot operate efficiently y