Macroeconomics Study Set 62

Business

Quiz 14 :

The Financial Crisis and the Great Recession

Quiz 14 :

The Financial Crisis and the Great Recession

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If you were watching house prices rise during the years 2000-2006, how might you have decided whether or not you were witnessing a "bubble"
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Housing bubble
Housing bubble refers to the rapid increase in the prices of houses; this increase in prices is derived by demand and by speculation and the confidence level in the real estate market that there would be profits and benefits in buying and selling of houses.
The 2000-2006 bubble scenario
The United States witnessed a huge hike in housing prices; the prices of houses in real estate increased from 60 to 90 percent during 2000-2006. This increase in housing prices was due to two major reasons. They are as follows:
• Increase in income
• Low mortgage interest
Increase in income increased the propensity to consume and the disposal of income; lower interest rate on mortgage loans allowed more people to buy houses.

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Explain how a collapse in house prices might lead to a recession.
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The decrease in the value of asset reduces the value of holdings of the people, so people consume less. This reduction in consumption decreases the demand, which in turn leads to a decrease in output, employment, and income. Consequently, this results in recession.

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Why do we say that deposits are "liabilities" of banks
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Liability
It is the amount of debt or obligation incurred by the bank.
Checkable deposits are liabilities to the banks
Banks create money through demand deposits and lending funds where the interest is collected for the principal amount lent by the bank.
These demand deposits are considered as a liability by the bank because they have to be repaid to the customers on their demand at any time.

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Explain why a mortgage-backed security becomes riskier when the values of the underlying houses decline. What, as a result, happens to the price of the mortgagebacked security
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Explain the basic idea behind the TARP legislation. Was that idea carried out in practice
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What factors do you think bankers normally use to distinguish "prime" borrowers from "subprime" borrowers
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(More difficult) In March 2008, the Fed helped prevent the bankruptcy of Bear Stearns. However, in September 2008, the Fed and the Treasury let Lehman Brothers go bankrupt. What accounts for the different decisions ( Note: You may want to discuss this question with your instructor and/or do some Internet or library research. The answer is not straightforward.)
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Create your own numerical example to illustrate how leverage magnifies returns both on the upside and on the downside.
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If the expected default rate on a particular mortgagebacked security is 4 percent per year, and the corresponding Treasury security carries a 3 percent annual interest rate, what should be the interest rate on the mortgage-backed security What happens if the expected default rate rises to 8 percent
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Explain how a collapse of the economy's credit-granting mechanisms might lead to a recession.
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During the financial crisis and recovery, stock market prices first fell by about 55 percent and then rose by about 65 percent. Did investors therefore come out ahead Explain why not.
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