Welfare Losses and Government Intervention : An Example From The Subprime Mortgage Crisis
We have been experiencing the welfare consequences of the subprime mortgage crisis, in which relatively small losses on subprime assets have triggered large reductions in wealth, employment and output. As stated in Krishnamurthy (2009), the direct losses due to household default on subprime mortgages are estimated to be at most $500 bn, but the effects of the subprime shock have been far reaching. In order to prevent such huge welfare losses, governments may intervene in the financial markets and implement policies to mitigate the effects of the initial financial shock. For the credit market view of the financial accelerator, one policy implementation is to break the link between borrower’s net worth and its ability to borrow as shown in the figure above.
There are various ways of breaking the mechanism of a financial accelerator. One way is to reverse the decline in the asset prices. When asset prices fall below a certain level, government can purchase assets at those prices, pulling up the demand for them and raising their prices back. The FED was purchasing mortgage-backed securities in 2008 and 2009 with unusually low market prices. The supported asset prices pulls the net worth of the borrowers up, loosening the borrowing limits and stimulating investment.
Read more about this topic: Financial Accelerator
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