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I have been tasked to explain the changes in economic performance of a particular country as part of my class assignment. In particular, I need to explain the changes in the inflation rate of Malaysia over the past 10 years. The general trend seems to be that over time, the fluctuations in the rate of inflation has become smaller, maintaining at 2-4% in recent years. However, there is this large fluctuation in the period from 2008 to 2010. I am quite sure this has got to do with the Great Recession of 2008. However, I am not quite sure what is the connection between a global financial crisis and large volatility in prices of goods and services.

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Given the expectations-augmented Phillips curve, national output which is less than the natural level of output (the level of GDP which is associated with full employment) causes deflationary pressure at an accelerating rate (assuming people's expectations of inflation is last period's inflation rate).

The financial crisis of 2008 was caused by a credit-driven asset price bubble. This was caused by financial institutions who invested in assets that were at the time priced at a value greater than their fundamental value. By holding these assets that were rising in price, they were used as collateral and/or used as capital buffers in order to make leveraged investments on these same overvalued assets. Causing a feedback loop, as these leveraged investments created a further increase in demand for these assets (raising their price, once more) which caused financial institutions to make further lending on these assets, which drives the asset price higher, and so on.

When the asset-price bubble "burst" and financial institutions subsequently made substantial losses (as they did not have enough capital to subsidise these losses) they had to cut down on their asset holdings to at least mitigate these losses, which caused a significant contraction in lending to the economy, as these financial institutions were more focused on collecting a large reserve base. A decrease in lending causes a decrease in investment in the economy, and subsequently decreases consumption, hence why aggregate demand decreased and the global economy was facing a period of mass deflation.

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  • $\begingroup$ Are you sure this is relevant for the context of Malaysia? Or is this more for the US? $\endgroup$ – Tan Yong Boon Nov 25 '18 at 2:20
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    $\begingroup$ Even if this was only relevant to the U.S. then this would cause a sharp decrease in U.S. imports, causing other countries to experience sharp decreases in exports, hampering aggregate demand, causing deflation. I am only trying to explain how a particular financial crisis can actually cause severe effects within the "real" domestic economy and the wider international markets. $\endgroup$ – plim Nov 25 '18 at 11:19
  • $\begingroup$ Ok that explains the deflation that was observed during the crisis in Malaysia. However, a sharp increase in price levels was also observed during the beginning of the crisis/on the eve of the crisis. Do you have any idea how that can be explained? I will accept your answer if you could help to give me satisfactory reply. $\endgroup$ – Tan Yong Boon Dec 18 '18 at 1:26

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