Question

Question 1

A. A recession might raise the natural rate of unemployment, explain how? (2 marks).

B. What were the mistakes of the following parties which led to the recession of 2008-2009?

1. Home buyers, 2. Government policymakers, 3. Investment banks.

Answer 1

Part A

A rise in unemployment caused by a recession may cause the natural rate of unemployment to increase. This is because when workers are unemployed for a time period they become deskilled and demotivated and are less able to get new jobs.The natural rate of unemployment will therefore include, Frictional unemployment and Structural unemployment. The frictional nature of the unemployment relates to the time lag between a worker moving from one job to the next. It is called as serach and wait unemployment. Structural unemployment is long-lasting unemployment that comes about due to shifts in an economy.This type of unemployment happens because though jobs are available, there’s a mismatch between what companies need and what available workers offer.For example, a worker who is not able to get a job because he doesn’t have the right skills.

Part B

The subprime mortgage crisis was the collective creation of the world's central banks, homeowners, lenders, credit rating agencies, underwriters, and investors.

Homebuyers

Homebuyers played a major role in recession of 2008- 2009. They bought very expensive houses which they could not afford.They were able to make these purchases with non-traditional mortgages and interest-only mortgages. These products offered low introductory rates and minimal initial costs such as no down payment. They expected prices to appreciate. So, this will allow them to refinance at lower rates and also to utilize the equity out of homes for some other spending. But unfortunately the housing bubble burst and prices went downward.

Government Policy Makers

Some economists have argued that the low rate interest policies of the Federal Reserve in the 2003-2006 period caused the housing price bubble.It was said that the low federal funds rate led to low mortgage rates that stimulated housing demand and encouraged the issuance of subprime mortgages, both of which led to rising housing prices and a bubble. Central banks flooded the markets with capital liquidity, which not only lowered interest rates, it also broadly depressed risk premiums as investors looked for riskier opportunities to boost their investment returns. Government lemding programmes which made affordable housing prices was one of the major cause of crisis.The limited regulation of non-depository financial institutions also resulted into crisis.

Investment Banks

Investment Banks added fuel to the fire. A large number of loans were made by lenders through use of secondary market mortgages. Lenders of loans sold off the mortgages in the secondary market and collected the originating fees. This made the availability of the capital more freely which increased liquidity in the market and set the stage for recession. A lot of the demand for these mortgages came from the creation of assets pooling mortgages together into a security, such as a collateralized debt obligation (CDO). In this process, investment banks would buy the mortgages from lenders and securitize them into bonds, which were sold to investors through CDO's.

Credit rating agencies and underwriters of the CDOs and other mortgage-backed securities could not forsee the high default rates of the securities. These agencies gave inaccurate high ratings and misguded the investors which aggravated the crisis.