Question

In: Economics

How, in general, can a financial crisis lead to a recession? What, in particular, precipitated the...

How, in general, can a financial crisis lead to a recession? What, in particular, precipitated the severe recession of 2007-2009? Include in your discussion what role the government, businesses, and consumers played in the economic downturn.

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Expert Solution

A financial crisis can have an adverse wealth effect; if assets lose value and people have poor expectations for the economy, spending and investment decrease, leading to recession. recession is defined as when businesses cease to expand, the GDP diminishes for two consecutive quarters, the rate of unemployment rises and housing prices decline.

  • Fiscal policy relies on the government’s powers of spending and taxation. Both taxation and government spending can be used to reduce or increase the total supply of money in the economy—the total amount, in other words, that businesses and consumers have to spend. When the country is in a Recession, the appropriate policy is to increase spending, reduce taxes, or both. Such expansionary actions will put more money in the hands of businesses and consumers, encouraging businesses to expand and consumers to buy more goods and services. When the economy is experiencing inflation, the opposite policy is adopted: the government will decrease spending or increase taxes, or both. Because such contractionary measures reduce spending by businesses and consumers, prices come down and inflation eases.

Now coming to the main question that "What, in particular, precipitated the severe recession of 2007-2009?"

Irrational exuberance in the housing market led many people to buy houses they couldn't afford. Everyone thought housing prices could only go up. many investors took advantage of low rates to buy homes just to resell. Others bought homes they couldn't afford thanks to interest-only loans then The first sign that the economy was in trouble occurred in 2006. That's when housing prices started to fall. At first, realtors applauded. They thought the overheated housing market would return to a more sustainable level.

This caught many homeowners off guard, who had taken loans with little money down. As they realized they would lose money by selling the house for less than their mortgage, they foreclosed. An escalating foreclosure rate panicked many banks and hedge funds. They had bought mortgage-backed securities on the secondary market and now were facing huge losses.By August 2007, banks became afraid to lend to each other because they didn't want these toxic loans as collateral. This led to the $700 billion bailout, and bankruptcies or government nationalization of Bear Stearns, AIG, Fannie Mae, Freddie Mac, IndyMac Bank, and Washington Mutual. Banks panicked when they realized they would have to absorb the losses. They stopped lending to each other. They didn't want other banks giving them worthless mortgages as collateral. No one wanted to get stuck holding the bag.  As a result, interbank borrowing costs rose. This mistrust within the banking community was the primary cause of the 2008 financial crisis,

AFTER THE CRISIS, BANKS REFUSE TO LEND, AND THE ECONOMY SHRINKS

Banks lend when they’re confident that they will be repaid. So when the economy is doing badly, banks prefer to limit their lending. However, although they reduce the amount of new loans they make, the public still have to keep up repayments on the debts they already have.The problem is that when money is used to repay loans, that money is ‘destroyed’ and disappears from the economy.So when people repay loans faster than banks are making new loans, it’s like draining the oil from the engine of a car: the economy slows down and prices decrease. As a result the economy risks slipping into a ‘debt-deflation’ spiral, where wages and prices fall but people’s debts do not change in value, leading to debts becoming relatively more expensive in ‘real’ terms. Even those businesses and people that weren’t involved in creating the bubble suffer, causing a recession.


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