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Mortgage Defaults and the Effect on Moey Supply

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Think of the role banks have in generating money in the economy. How do the mortgage defaults from the last economic recession in the U.S. affect the money supply? What will happen to interest rates as a result?

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Solution Summary

This solution discusses how mortgage defaults affect the economy. When mortgage defaults increase, banks have less money to lend out. At the same time, banks are also very cautious in lending out to new borrowers. As a results the money supply in the economy decreases. Eventually the equilibrium interest rates will go up given no change in the demand for money. This solution goes into depth and explains these economic concepts.

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Banks affect the money supply by lending out their deposits in access of their reserves. Eventually, the money supply in the economy will be affected through the money multiplier.

Money supply = money multiplier (x) monetary base.

When the monetary base increases, the money supply will increase as well and vice versa. The monetary base is ...

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