A financial crisis occurs when financial markets experience sudden and severe losses, or when investors lose confidence in the financial sector or the economy as a whole. In the economy during a financial crisis, people often have to contend with either inflation or deflation. Lending normally becomes more restrictive, and this contributes to rising unemployment. A general weakening of the economy during a financial crisis can even lead to lead to political instability.
Typically, banks are at the center of a financial crisis because consumers and businesses rely heavily on banks for credit to cover short-term expenses, while savers rely on income from bank deposits to generate income for retirement years. A financial crisis often begins when a bank experiences high numbers of loan defaults as a result of the economy slowing down after a period of rapid growth. Banks curtail new lending to reduce further losses, which means businesses cannot obtain loans needed to finance product development and company expansion. Businesses stop hiring because expansion plans have to be put on hold, cut existing jobs to save money, and attempt to build up cash reserves that can offset the loss of available credit.
Banks react to the effect of unemployment on the economy during a financial crisis by curtailing consumer lending because rising unemployment usually leads to higher loan default rates. When home buyers become scarce, home owners attempting to sell their homes begin to lower their asking price, and this leads to deflation as prices in general start to fall. Falling prices result in a slowdown in production because people have surplus cash, but the slow down in production often leads to increased unemployment. In a deflationary economy during a financial crisis, savers have increased spending power but due to high unemployment, increasing numbers of people have no income.
An economy during a financial crisis can also experience rapid inflation as investors lose confidence in the government and its ability to cover its debt obligations by raising taxes. Investors demand higher returns on government bonds, and this drives up interest rates on other kinds of investments as well as commodities. Rising prices mean that consumers have less spending power and spend a higher percentage of their income on basic needs, such as food and housing, rather than on luxury items.
Sometimes, a financial crisis can impact the entire world because national economies are intertwined due to the import and export of goods. Nations lacking liquidity reduce imports, which means other trading partners lose income and have to reduce spending. A financial crisis can have a domino effect in a free market economy, and only countries with isolationist economic policies avoid the damaging effects of a global economic crisis.