The financial crisis of 2007–2008
The bursting of the United States of America was the primary cause of the financial crisis that occurred around 2007 to 2009. Many borrowers were encouraged to assume risky mortgages in the prediction that they would quickly refinance at easier terms. The reason behind this encouragement was because there was an increase in loan incentives such as promising initial terms and long-term trend of increasing housing prices (Gertler & Gilchrist, 2018). However, borrowers were not able to refinance since the interest rates started to improve and the costs of housing started to drop in 2006-2007. Foreclosure activity and default increased as the initial term expired, adjustable rate mortgage interest rates reset higher, and home prices fell.
The fall of housing price resulted in the evaporation of global demand for mortgage-related securities. This phenomenal became apparently by July 2007, the investment bank Bear Stearns declared that a pair of its hedge funds had collapsed (Gertler & Gilchrist, 2018). These funds had been invested in securities whose value was derived from mortgages. The investors demanded the hedge funds to give additional collateral when the value if securities fell. This occurrence created a low rate of selling in these securities which further lowered their value.
Some several entities, prepared for the rise and fall of the housing prices and included securities that were widely held by the financial organizations. In the previous year prior crisis, the government of the United States borrowed a lot of money from the developed countries such as Asia and other states that produced and exported oil (Gertler & Gilchrist, 2018). The U. S. interest rate combined with this borrowed funds led to easy credit terms and conditions, which contributed to both housing and credit bubbles. There was an introduction of various types of loans such as credit cards, mortgage, and auto, and the consumers assumed a single load of debt.
As part of the credit and housing boom, the number of financial contracts referred to as mortgage-backed securities significantly increased. The value of these mortgage-backed securities is derived from housing prices and mortgage payments (Foote & Willen, 2016). These financial innovations led to institutions and investors being in a position to invest in the U. S. housing market. A major global financial organization that had borrowed and invested in MBS recorded massive losses. As the crisis expanded to other sectors of the economy from the housing sector, loss and defaults on other types of loans drastically increased. It is estimated that a total of trillions of U. S. dollars were lost.
The losses that were experienced by financial organizations on their mortgage-related securities made it impossible for them to lend loans to the investors and citizens. The absence of loans led to slowed economic growth and development (Foote & Willen, 2016). Also, lending between banks dried up and the loans to non-financial was not spared either. The central bank was pushed to intervene with concerns regarding the stability of vital financial organizations. The bank (central bank) provided funds that encouraged lending and restored trust in the commercial paper markets
Monetary policy and cyclical asymmetry
Generally, the Federal Reserve controls the monetary policy. When the Federal Reserve either contracts or expands the money supply in the country’s economy, it has an effect on business cycles. It is important to note that the American economy moves in cycles, or cyclically. Therefore, the policymakers and those at FED should make a decision that will not interrupt the cyclical movement of the economy (Guerrieri & Lorenzoni, 2017). Most of the economies which are characterized by the free market are cyclical which implies that the flow and ebb. Also, business cycles can either move in negative or in a positive direction. Cyclical asymmetry suggests that imbalances are formed in an economy caused by factors that are also cyclical.
When economists say that monetary policy can exhibit cyclical asymmetry, imbalances that are asymmetrical are formed in an economy as a result of monetary policy being either expanded or restricted. A liquidity trap is defined by the economists as the economic occurrence where the interest rate falls to a very low level such that people of the state tend to hold cash rather than buying bonds since there is no significant return (Nakata & Schmidt, 2019). In addition, people will keep money in standard deposit accounts. Such accounts include saving and checking accounts rather than other alternative investment despite the central banking system trying to stimulate the economy through strategies such as injecting additional funds. The primary reason for this phenomenon is just because people are having a belief of negative in future negative occurrence (Guerrieri & Lorenzoni, 2017). This situation occurs even when the yields are high. A liquidity trap can create cyclical asymmetry since the interest becomes so low such that it becomes a challenge to the institutions and banks to have enough funds to loan since the demand for cash is exceptionally high.
The trap is significant to the policymakers since the policymakers and those people working for the Federal Reserve must be informed of the interest rate movement. In this case, they are more concerned with the situation where falling to a very low level where the demand for money exceeds the amount that is available (Nakata & Schmidt, 2019). Also, if all people are holding cash, the action will also lead to high levels of increase in the price of commodities since there is a lot of money in the economy or circulation. In other words, inflation will set in as a result of many people having a lot of cash.
Foote, C. L., & Willen, P. S. (2016). The subprime mortgage crisis, the. In Banking Crises (pp. 324-336). Palgrave Macmillan, London.
Gertler, M., & Gilchrist, S. (2018). What happened: Financial factors in the Great Recession. Journal of Economic Perspectives, 32(3), 3-30.
Nakata, T., & Schmidt, S. (2019). Gradualism and liquidity traps. Review of Economic Dynamics, 31, 182-199.
Guerrieri, V., & Lorenzoni, G. (2017). Credit crises, precautionary savings, and the liquidity trap. The Quarterly Journal of Economics, 132(3), 1427-1467.