Question

Choose 1 of the following topics related to the Great Recession:

• The housing price bubble, collapse, foreclosures, bailout of underwater mortgages
• Subprime mortgages and derivatives, bailout of FNMA, Freddie Mac and AIG
• The banking industry crisis, bailout of commercial and investment banks

Write a 350- to 700-word analysis of 1 of the following corrective actions taken by the Federal Reserve as a result of the crisis:

• Quantitative easing
• Purchase of toxic assets from financial institutions
• Paying interest on reserve balances

Address the following in your analysis:

• Actions taken by the Federal Reserve to mitigate the crisis
• How the corrective action helped to restore stability to the financial system
• How the corrective action should prevent recurrence of a similar crisis

Answer 1

Housing demand increased due to increase in sub prime loans. Thus housing prices were increasing. Sanctions of sub prime loans increased further increasing housing demand and prices even more. Now was the tipping point, where the demand reached its maximum along with the price, suppliers produced a lot and supply increased. Due to all of this supply was very high, while demand was artificially created. Housing price collapse was inevitable.

Due to this collapse in housing prices, sub prime borrowers defaulted on their loans. There was a mass default. This lead to liquidity crunch for banks. Now, banks were holding properties(mortgage) to sell. Now, to create liquidity Fed used quantitative easing. This was need of the hour. As the economy was into recession, it would have come back only by stimulating demand. Demand would increase if income of people increase or if they get access to credit.

Quantitative easing solved both the things, it increased liquidity and increased demand. How?

Printing new money and providing it to banks is what Fed did. Fed also asked banks to provide credit to the borrowers. So, interest rates were decreased. What followed was an increase in aggregate demand and revival of the economy.

Above picture shows the recession (deflationary gap). To move out of this Fed did quantitative easing and tried pushing AD curve to right as shown in below diagram.