Question

Due to the most recent Subprime mortgage crisis, most of the banks are uncertain about deposit outflows. Given everything else unchanged, how does this affect money supply in the economy? Explain. (10 points)

Answer 1

A)The crisis made most financial regulators to completely overhaul the way banks were monitored and shaped the economic decisions of many countries in the next decade. It was the greed of bankers that led to risky investments which eventually affected economies round the globe.

One of the most distinctive features of the recession was the fact that there was a sudden spike in the number of mortgages or loans taken out by Americans since 200 had suddenly spiked.

Most of these were Subprime Mortgages .Subprime mortgages are called so when the borrower has an impaired credit history i.e. the consumer has a history of defaults and late-payment.The subprime mortgages have a significantly high interest rate when compared to prime/normal mortgages. In accounting terms, the more subprime mortgages given out, higher is the future payout for the firm, but this is not risk adjusted.

People had bought houses at high prices; they were assured by real estate agents and credit agencies that the prices would go even higher. With this assumption people believed that they would be able to sell the houses at a profit to repay the huge mortgages they had taken to buy the houses. Even though the average income of consumers was rising, the indiscriminate spending pattern meant that Americans were running out of savings. Over the years people had taken mortgages to buy expensive houses, without savings they found themselves unable to pay the monthly installations of the amount borrowed. Hence delinquency/default rate rose quickly in 2007 as house prices stagnated.

Since the savings were out and their were huge mortgages Real personal Consumption declined. This led to a shift of LS curve towards left Decreasing the output to Y' .Now to maintain the intrest rate the LM curve shifts and the Output is further decreased to Y".

Monetary Policy

Conventional monetary policies have been pursued with Central Banks cutting their policy interest rates dramatically.By reducing real interest rates the Central Banks helped stimulate domestic demand through the six channels of the transmission mechanism.Lowering the interest rate through a downward shift of the LM curve. This helped offset the leftward shift of the IS curve, encouraging the maintenance of output levels at Y"' in the short-run as indicated in figure.

The reduction in intrest rates were quite drastic for example the Fedral Reserve cut it down to 0-0.25% which is almost zero.