Macroeconomics

This document provides an analysis of the credit crisis in macroeconomics. It discusses the causes of the crisis, including defaults on sub-prime mortgages and falling house prices. It also examines the role of the Central Bank, banks, investors, and insurance companies in the crisis. The document concludes by highlighting the responsibility of investment bankers in creating innovative financial products.

MACROECONOMICS
STUDENT ID:
[Pick the date]

MACROECONOMICS
Question 1
The crisis began primarily because of the defaults on the sub-prime mortgages. The sub-
prime mortgages were extended to home owners without any credit checks. Meanwhile, from
2005 onwards, there was an increase in the interest rate leading to the increase in the
mortgage payments. This resulted in home owners defaulting on their monthly repayments.
The initial defaults did not lead to any crisis but when the default rate on mortgages
increased, there was an increase in the supply of houses leading to falling prices of these
assets. Considering the falling house prices, the home owners who were making their
mortgage payments willingly defaulted on their payments. This is because it did not make
commercial sense to pay a higher price for an asset which is available at significant discount
in the market. The net result was that money could not be recovered by bank, investors by the
sale of houses leading to a credit crisis.
Question 2
During 2000-2001, there was a significant decline in the interest rates by the Federal Reserve
(US Central Bank) which got reduced to 1%. The key reason behind this drop in interest rate
was to strengthen the US economy by ensuring that aggregate demand is increased by
reducing the cost of borrowing. This was done in the aftermath of the dotcom bust and the
September 11 terrorist attacks. The lowering of interest rates was part of an expansionary
policy on the part of the Central Bank which is aimed at boosting growth. This type of policy
is usually adopted when there is slowdown in economic growth and a boost is required. A
similar scenario existed in the US at the time when there was a bust of the dot com bubble
coupled with the terrorist attack on US.
Question 3
In order to decide on the party most responsible for the credit crisis, it is imperative to outline
the role played by each of the parties. The Central Bank was responsible for the crisis
primarily because it allowed the sub-prime lending to happen especially at a time when the
interest rate had started hardening. It is quite surprising that the Federal Reserve could not see
the potential long term outcome of the unabated lending done by the banks. Banks were
2

MACROECONOMICS
responsible for introducing the sub-prime lending on the premise that even if the borrowers
defaulted, the outstanding amount can be recovered by liquidating the asset. The banks never
thought that house prices cannot go up indefinitely especially at a time when the Central bank
was hardening the rates. The investors and insurance companies were also responsible for
development of securities such as CDO and CDS owing to demand for the same. However,
in my opinion the investment bankers were the one who were the most responsible for this
crisis considering how they leveraged and through their financial wizardly created innovative
financial products. Without this financial securitization of the loan books, the crisis would
have not taken place and any impact would have been much lesser.
3