Question

How does the concept of asymmetric information help to define a financial crisis?

Short answer

Financial frictions caused by asymmetric information during a financial crisis can halt or severely disrupt funds flow, with detrimental outcomes for the economy.

Step-by-step solution

Concept introduction

Asymmetric information occurs when one party possesses more information than the other, allowing that party to gain an advantage over the information-inferior party. =There is a financial crisis when there is an unusually large disruption of the flow of information in financial markets. As a result, funds cannot be channeled to households and firms that can make use of them.

Explanation 

In financial transactions, the problem of information asymmetry is often prevalent. It generally does not hinders the efficient working of the financial system. However, it can cause problems during a financial crisis as the information asymmetry is intensified. The financial frictions caused by information asymmetry cause the flow of funds to be hindered. this can adversely impact economic activity.