Question

Case study#1: From Housing Bubble to Housing Bust

The United States experienced rising home ownership rates for most of the last two decades. Between 1990 and 2006, the U.S. housing market grew. Homeownership rates grew from 64% to a high of over 69% between 2004 and 2005. For many people, this was a period in which they could either buy first homes or buy a larger and more expensive home. During this time mortgage values tripled. Housing became more accessible to Americans and was considered to be a safe financial investment. The housing bubble began to show signs of bursting in 2005, as delinquency and late payments began to grow and an oversupply of new homes on the market became apparent. Dropping home values contributed to a decrease in the overall wealth of the household sector and caused homeowners to pull back on spending. Several mortgage lenders were forced to file for bankruptcy because homeowners were not making their payments, and by 2008 the problem had spread throughout the financial markets. Lenders clamped down on credit and the housing bubble burst. Financial markets were now in crisis and unable or unwilling to even extend credit to credit-worthy customers.

The housing bubble and the crisis in the financial markets were major contributors to the Great Recession that led to unemployment rates over 10% and falling GDP. While the United States is still recovering from the impact of the Great Recession, it has made substantial progress in restoring financial market stability through the implementation of aggressive fiscal and monetary policy.

The economic history of the United States is cyclical in nature with recessions and expansions. Some of these fluctuations are severe, such as the economic downturn experienced during Great Depression of the 1930’s which lasted several years. Why does the economy grow at different rates in different years? What are the causes of the cyclical behavior of the economy? This chapter will introduce an important model, the aggregate demand–aggregate supply model, to begin our understanding of why economies expand and contract over time.

Question: Analyze the above Case Study from the Aggregate Demand and Aggregate Supply Theory.

Answer 1

To understand why the economy grows at different rates in different years, we need to understand the business cycles which is how the economy works showing the fluctuations in the real economic activities. The phases of the business cycles involve expansion, peak, contraction and trough.

Now, the question further goes down to a basic level of why these business cycles occur. In order to answer that, we have to see how the different components of the market affect the aggregate demand and aggregate supply situation. Further how does the economy respond to these changes in the aggregate demand and aggregate supply situations. In this housing example, when the financial investment in housing got cheaper, the demand for investing in housing increased as a result. Due to this more and more people starting investing in buying houses which was available too. However on the other hand, we know that demand and price has an inverse relationship. Thus the prices of housing was falling and demand rising concomitantly.

On the other hand the aggregate supply was also very high considering the demand for it. But gradually, the falling prices reduced the wealth of the homeowners as a result of which they were unable to pay for the houses. Therefore the demand for credit market rose but with such a background of the poor financial structure of the economy, the creditors could not help them out of this. Thus the recession phase took place which had to taken out of with the help of government fiscal and monetary injections.