Economists viewed the economic disaster of 2007 as the worst economic disaster since 1929 when the “Great Depression” occurred. Even though the Federal Reserve and US Treasury Department put forth stringent efforts to avoid the U.S. banking system from collapsing but it seemed to be inevitable (Amadeo, 2016).
In 2006, there were signs pointing to an economic problem. Housing prices began to fall; financial institutions started to lend money to people who planned to buy a home at these reduced prices. Banks were allowing these borrowers to take out loans that covered 100% of the value of their homes. There wasn’t a problem with the loans, but there was a problem with these borrowers that had questionable credit and now could potentially default on these home loans. These buyers with credit issues needed help being able to purchase a house at this reduced price and didn’t have enough time to improve their credit. This is where Subprime Mortgage Loans came into play. This type of loan was available to borrowers that had high-risk credit. The only catch was these were available, but the interest rate was higher than other regular loans.
Banks and financial institutions had granted loans to borrowers with no money down. With no money down the financial institution would simply collect the interest and principal payments over the next several years. This also means that if there are no large amounts of money coming into the financial institution they don’t have money to loan to other borrowers. As banks sell the mortgages, they can get cash to make other loans available. The entity that the bank sold your mortgage to now groups your mortgage together with other similar mortgages that have been purchased. They pool these mortgages together with common characteristics, for example, similar interest rates, maturities, etc. This pool of mortgage loans is called Mortgage-Backed security- these are securities that represent an interest in a pool of mortgage loans. The mortgage-backed securities industry can provide lenders more cash to make more mortgage loans(Amadeo, 2016).
As the housing process started to fall and borrowers started to default on their mortgages, the value of these mortgage-backed securities became worth very little to nothing. Financial investors that had held the securities started to default on the loans that they had with the banks. Banks were in turn forced to write off these bad debt loans. This financial crisis that happened in 2008 proved that banks could not regulate themselves without some government oversite (Amadeo, 2017).
When the economy is a recession, monetary policy doesn’t have as big a role as during inflation. “Monetary policy is how central banks manage liquidity to create economic growth” (Amadeo, 2017 para 1). The term liquidity refers to how much money there is in supply which would include credit, cash, checks and mutual funds.
Cyclical asymmetry is a term that “refers to a large imbalance in economic factors that occur due to cyclical reactions by a market or nation” (McAfee, 2006). Central Banks and the Federal Reserve’s primary roles are to control inflation and reduce employment as it seeks a healthy economic growth. Contractionary monetary policy reduces inflation by raising interest rates and selling securities. This restrictive monetary policy is influential in contracting economic activity (Amadeo, 2017).
Expansionary monetary policy reduces unemployment by lowering interest rates and buying securities from member banks. This type of policy is weak for stimulating the economy yet, in turn, helps to avoid recession and increase liquidity. Even when there is an increase in liquidity, there are times when borrowers are not willing to spend money due to unpredictability in the economy. This is referred to as a “liquidity trap” (Amadeo, 2017).
Cyclical asymmetry and the possibility for a liquidity trap are important to policymakers in that monetary policy can effectively fight inflation, but that doesn’t mean it’s successful in bringing the economy out of a recession(Hoffmann, 2009).
Monitoring Economic Growth is very important to all countries. By monitoring each country’s economy for increases or decreases helps its leaders understand where exactly the issues are taking place and where to go to make improvements.
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Amadeo, K. (2017). 2008 Financial Crisis: Causes, Costs and Could It Reoccur? US
Economy. Retrieved from https://www.thebalance.com/2008-financial-crisis-3305679.
Amadeo, K. (2017) What Is Monetary Policy? Objectives, Types, and Tools- 6 ways to Legally Create Money Out of Thin Air. US Economy. Retrieved from https://www.thebalance.com/what-is-monetary-policy-objectives-types-and-tools-3305867.
Hoffmann, A. (2009) A Vicious Cycle of Manias, Crashes and asymmetric Policy Responses –An
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Szulczyk, K. (n.d). Time Lags and Targets. Boundless. Retrieved from https://www.boundless.com/users/233416/textbooks/money-banking-and-international-
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