Economics for Manager: Impact of Financial Innovations on Global Financial Crisis

Economics for Manager 1
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Economics for Manager
By
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<Lecturer’s Name and Course Number>

Economics for Manager 2
Executive Summary
Financial crisis greatly impacted the global economy in the period between 2006 and 2009 as
financial systems were negatively impacted by the eventual fall in demand for financial products
and services. The financial crisis mainly occurred due to financial innovations by developed
economies to create more safe debt instruments without prior consideration of global imbalances.
As such, policies that were formulated to address the global imbalances exposed the economies
to the eventual financial crisis. Reversing of capital inflows as a macroeconomic policy,
securitization of low quality assets and creation of more safe assets were some of the policies
that greatly contributed to occurrence of the global financial crisis.

Economics for Manager 3
Introduction
Global economy was hit with a financial crisis in the period between 2006 and 2009 that caused
total collapse threats to the financial systems across the globe. The above occurred when a
number of governments across the world started to bailout uninsured financial entities which
further led to stock price reductions. As such, investments and consumer lending significantly
reduced as banks did not offer short and long term credit facilities due to the financial crisis
(Caballero 2010 p.15). Therefore, the report will mainly focus on finding out whether the global
financial crisis was caused by the financial innovations or collapse of housing bubble.
Question 1 (a)
Below is a representation of how debt contracts have large externalities on the mortgage owners
which increases the risks of loss as compared to lenders.
Supply
House Prices
Demand
Q1 Qe Q2
Quantity (US dollars)

Economics for Manager 4
From the above illustration, debt contract increases possibilities of loss to the home owners
particularly in times when prices of houses reduce due to economic downturns. In such a case, a
house owner may not be in position to meet specified mortgage payments when house prices fall
and mortgage balance remains unchanged. When house prices fall, their demand significantly
declines from Qe to Q1 which is an indicator of a loss to house owners. On the other hand,
economic downturns can lead to increases in supply of mortgage houses implying that as house
prices increase, their supply will also increase from Qe to Q2. As a result, debt contracts inflict
loss unto home owners before the lenders can incur any loss when house price fall as showed on
the above illustration (Alistair 2009 p.25).
Question 1 (b)
Coase theorem emphasizes that all parties that are affected by a given externality should engage
in bargaining so as to arrive at an efficient outcomes of the trade. In application to standard debt
mortgage contract, Coase theorem can help to mitigate negative externality by creating a
bargaining atmosphere for the lenders and borrowers without prior consideration of initial
property rights (Courses.lumenlearning.com 2019).
Question 2
Shared responsibility mortgages are mainly focused on ensuring that mortgages are securitized in
home mortgage marketplaces by housing finance of United States. Shared responsibility
mortgages mitigate negative externality associated with standard debt mortgages by encouraging
the government to introduce equity related mortgages. In such a case, house owners are protected
from unexpected downturns in mortgage markets implying that unexpected fall in house prices
does not affect their capability to make mortgage payments (International Monetary Fund 2009).