Question

Write a short essay in which you identify the key factors that changed the demand for and supply of funds during the credit crisis and offer an explanation for why those factors caused a major decline in market interest rates. What lessons may be learned from the credit crisis that could prevent such an abrupt decline in the demand for funds in the future?

Answer 1

The financial crisis commenced in late 2000 is widely referred as “Great recession” in which liquidity dried up & credit flows to economy slowed down. The crisis was caused by many factors, important among them was the ability to create new lines of credit which reduces flow of money & slowed economic growth. We will discuss the factors in detail below.

1) The housing bubble: This bubble started to form with an increase in demand for real estate. The cheap credit which made it too easy for people to buy houses or real estate based on pure speculation, created more money into the system. People wanted to spend that money into real estate only which increased demand for loanable funds & caused inflation. Household debt rose significantly relative to their disposable income. This tide of toxic mortgages resulted in fall of major financial institutions. Large investment banks connected the housing market to the large supply of savings which aroused from an increased demand for high yield investment. This was done by innovating new securities termed as investments, which fueled housing bubble in the economy. This led fed to reduce interest rates to counter rapidly receding inflationary pressure & risks.

2) Debt purchase by equity firms: private equity firms leveraged billions of dollars of debt to buy companies & created hundreds of billions of dollars in wealth by simply shuffling paper without creating anything in value. Mortgage brokers determined who got loans & passed on the responsibility of those loans in the form of mortgage backed assets. These risky mortgages soon became ticking time bomb & just went off creating a credit crisis in the economy. The monetary authorities were forced to reduce interest rates to stabiles the financial system & counteract the adverse impact of credit crisis on the economy.

There are many lessons we can learn from this crisis to prevent such an abrupt decline in the demand for funds in the future.

Countries need early actions to enhance debt resolution framework & regulatory approach in banks. Fiscal adjustment is necessary to reduce public debt & restore sustainability. It is recommended to restructure debt early & when necessary.