In 2008 and 2009, the US economy and many others around the world experienced a financial crisis

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In 2008 and 2009, the US economy and many others around the world experienced a financial crisis and a severe downturn in economic activty. In many ways, it was the worst macroeconomic event in more than half a century. The story of this downturn begins a few years earlier with a substantial boon in the housing market. The boom was, in part, fueled by low interest rates. In the aftermath of the recession of 2001, the Federal Reserve lowered interest rates to historically low levels. Low interest rates helped the economy recover, but by making it less expensive to get a mortgage and buy a home, they also contributed to a rise in housing prices. In addition to low interest rates, various developments in the mortgage market made it easier for subprime borrowers – those borrowers with a higher risk of default based on their income and credit history – to get loans to buy homes. One development was securitization, the process by which a financial institution (specifically, a mortgage originator) makes loans and then (with the help of an investment bank) bundles them together into financial instruments called mortgage-backed securities. These mortgage-backed securities were then sold to other institutions (such as banks and insurance companies), which may not have fully appreciated the risks in these securities. Some economists blame inadequate regulation for these high-risk loans. Others blame misguided government policy: some policies encouraged this high-risk lending to make the goal of home-ownership more attainable for low-income families. Together, these many forces drove up housing demand and housing prices. From 1995 to 2006, average housing prices in the United States more than doubled. The high price of housing, however, proved unsustainable. From 2006 to 2009, housing prices nation-wide fell about 30 percent. Such price fluctuations should not necessarily be a problem in a market economy. After all, price movements are how markets equilibrate supply and demand. In this case, however, the price decline had two related repercussions that caused a sizable fall in aggregate demand. The first repercussion was a substantial rise in mortgage defaults and home foreclosures. During the housing boom, many home owners had bought their homes with mostly borrowed money and minimal downpayments. When housing prices declined, these home owners were underwater (they owed more on their mortgages than their homes were worth). Many of these homeowners stopped paying their loans. The banks servicing the mortgages responded to these defaults by taking the houses away in foreclosure procedures and then selling them off. The banks’ goal was to recoup whatever they could from the bad loans. As you might have expected from your study of supply and demand the increase in the number of homes for sale exacerbated the downward spiral of house prices. As house prices fell, spending on the construction of housing also collapsed. A second repercussion was that the various financial institutions that owned mortgagebacked securities suffered huge losses. In essence, by borrowing large sums to buy high-risk mortgages, these companies had bet that house prices would keep rising: when this bet turned bad, they found themselves at or near the point of bankruptcy. Because of these large losses, many financial institutions did not have funds to loan out, and the ability of the financial system to channel resources to those who could best use them was impaired. Even creditworthy customers found themselves unable to borrow to finance investment spending. As a result of all these events, the economy experienced a large contradictory shift in aggregate demand. Real GDP and employment in the US both fell sharply. Real GDP declined by almost 4 percent between the fourth quarter of 2007 and second quarter of 2009. The rate of unemployment rose from 4.4% in May 2007 to 10.1% in October 2009. The problems were not confined just to the United States. The complex integration of the global financial system meant that banks in other countries were also affected and GDP in many developed countries fell and unemployment rose. As the crisis unfolded, the US and other governments responded in a variety of ways. Three policy actions – all aimed in part at returning aggregate demand to its previous levels – are most noteworthy. First, the Fed cut its target for the federal funds rate from 5.25% in September 2007 to about zero in December 2008. At one stage six leading nations including the United Arab Emirates announced a collective cut in interest rates to highlight the seriousness of the economic situation worlwide and the importance of taking speedy action. The Federal Reserve and some other central banks also started buying mortgage-backed securities and other private loans in open-market operations. By purchasing these instruments from the banking system, central banks provided commercial banks with additional funds in the hope that the banks would make loans more readily available. Second, in an even more unusual move in October 2008, Congress appropriated $700 billion for the Treasury to use to rescue the financial system. Similar “bail-outs” were announced in other countries too. The goal was to stem the financial crisis on international markets and make loans easier to obtain. Much of these funds were used for equity injections into banks. That is, the Treasury put funds into the banking system, which the banks could use to make loans: in exchange for these funds, the US government and other governments became a part owner of these banks, at least temporarily. Finally, when Barack Obama became president in January 2009, his first major initiative was a large increase in government spending. After a relatively brief congressional debate over the form of the legislation, the new president signed a $787 billion stimulus bill on February 17, 2009. Such fiscal stimulus packages were also announced in many other leading economies and those of emerging nations such as China. The recovery from this recession officially began in June 2009. But it was, by historical standards, only a meager recovery. From 2010 through 2012, real GDP growth averaged 2.1% per year, below the average rate of growth of about 3%. Unemployment fell from its peak but remained high: in April 2013, it was 7.5%, about 3 percentage points higher than it was before the downturn began.

Explain the different phases of business cycle. What happens to production, income and employment levels in the different phases of business cycle? (5 marks)
What was the cause of the boom in the housing market in the US economy after the recession in 2001? Explain its effect on GDP and the price level in the economy. Is actual GDP greater or less than potential GDP in this scenario? (6 marks)
What is natural rate of unemployment? Explain. (10 marks)
It is not possible for any economy to have zero unemployment. Give reasons to support your answer. Does the US economy have zero unemployment in the above situation? Explain. (4 marks)

Question 2 (20 Marks)

Using AD & AS diagrams, explain the effect of a substantial fall in the housing prices on the GDP and the unemployment level of the US economy during financial crisis in 2008 and 2009.(10 marks)
In the above situation, is the US economy at the natural rate of unemployment? Explain the type of unemployment observed by the US economy. (10 marks)

Question 3 (25 Marks)

What is monetary policy? Describe any one tool of monetary policy that was used by the Federal Reserve to correct the economy. Draw a diagram to show the effect of this policy in the money market. (10 marks)

b) Define fiscal policy. Did the government use any fiscal policy, during financial crisis to help in the recovery of the economy? Explain the tool of the fiscal policy that was used by the government in this scenario. (7 marks)

c) Draw AD & AS diagram to explain the effect of the policies used by the Federal Reserve and the government, on the GDP and unemployment levels of the US economy. (8 marks)