BFalling asset values reduce firms' net worth, raising the external finance premium and cutting investment, which further depresses asset values
CBanks reduce lending because regulators tighten capital requirements during downturns
DLower housing prices reduce construction employment, which reduces aggregate demand through the multiplier
The financial accelerator operates through the net worth channel: falling asset prices erode collateral and net worth, making borrowers appear riskier. Lenders widen credit spreads, raising the cost of external funds. Higher borrowing costs reduce investment, which depresses economic activity and asset prices further — each round amplifying the initial shock. Options A, C, and D are real effects but are not the financial accelerator mechanism; they describe demand-side multiplier effects or regulatory responses, not the credit-market feedback loop.
Question 2 True / False
The financial accelerator is symmetric — it amplifies downturns but not expansions.
TTrue
FFalse
Answer: False
The financial accelerator amplifies both contractions and expansions. During booms, rising asset prices increase net worth, lower credit spreads, encourage borrowing and investment, and push asset prices higher still. This symmetric amplification is why the mechanism contributes to boom-bust cycles. The asymmetry in public perception (the accelerator is most visible in crises) does not mean it is absent during expansions — it actively inflates the boom that precedes the bust.
Question 3 True / False
A borrower's net worth increases substantially due to rising collateral values. According to the financial accelerator framework, the external finance premium will rise.
TTrue
FFalse
Answer: False
The external finance premium moves inversely with net worth. When net worth rises — because collateral is worth more and the borrower has more 'skin in the game' — lenders face less risk, and the premium they charge above the risk-free rate falls. Credit becomes cheaper and more accessible. This is the mechanism by which rising asset prices during booms stimulate further borrowing and investment, completing the upward feedback loop.
Question 4 Short Answer
Why is the mechanism called a financial 'accelerator' rather than a financial 'creator' of shocks?
Think about your answer, then reveal below.
Model answer: The financial accelerator does not generate the original shock — it amplifies and propagates shocks that originate elsewhere (productivity declines, commodity price swings, etc.). A 1% drop in productivity might cause a 3% drop in investment once the accelerator is operating. The mechanism takes small or moderate disturbances and turns them into larger, more persistent downturns (or booms) by feeding back through credit markets. Without the financial frictions, the same shock would produce a smaller, shorter-lived effect.
This distinction is important for policy. If the financial system were merely a passive reflector of real shocks, there would be little value in financial regulation. But because it actively amplifies shocks, macroprudential policy — limiting leverage buildup during booms — can reduce the fuel available to the accelerator and dampen future cycles. The 2008 crisis was a canonical demonstration: what began as a housing correction became a global financial crisis because the accelerator was operating at full force.
Question 5 Multiple Choice
During the 2008 financial crisis, a bank's balance sheet deteriorates as mortgage-backed securities fall in value. Walking through the financial accelerator logic, what happens next?
AThe bank lowers interest rates to attract more deposits and restore its balance sheet
BThe bank's reduced net worth raises its cost of funding, causing it to cut lending, which depresses economic activity and asset prices further
CThe bank sells profitable assets to offset losses, restoring net worth without macroeconomic consequences
DThe bank's losses are absorbed by deposit insurance, breaking the accelerator feedback loop
When a bank's net worth falls (assets worth less than expected), it faces a higher external finance premium on its own borrowing and becomes more cautious about lending. Reduced credit availability raises borrowing costs for firms and households, cutting investment and spending. This depresses asset prices further, eroding net worth again — completing the feedback loop. Options C and D might partially help but don't break the mechanism: fire-sale asset sales can depress prices further (amplifying), and deposit insurance doesn't directly address the bank's willingness to extend new credit.