Question

In your own words, explain the meaning and significance of a Credit Crunch.

Answer 1

A credit crunch is a situation in an economy when the availability of credit/loans in the overall economy is significantly reduced.

A credit crunch can occur due to various reasons :

• Monetary controls by the government or central bank. High reserve requirements for banks is one method that central banks/governments use to reduce the money supply in an economy.
• Banks expect higher defaults, and therefore are wary of lending

A credit crunch restricts economic expansion as there is shortage of funds for fresh investments. Lending is restricted to high quality borrowers, as lenders are more cautious of lending to low quality borrowers. Hence, those who need credit the most are cut off from lending institutions.

Due to credit crunch, economic growth may slow, or a recession could happen. These could result in rising unemployment.