The boom in the housing market preceding the crisis was created through offering and promoting unregulated subprime mortgages in pursuit of stimulating demands to combat the slowing down in the aftermath of the busting of the dotcom bubble which led to a growth in the housing market that exceeded incomes finally culminating to the collapse.
To understand the present global recession and its causes, it is pertinent to first understand any economic recession theoretically. According to Keynesian effective demand framework, a fall in real aggregate national income is triggered by a reduction in the effective aggregate demand (AD) which is composed of planned real aggregate consumption expenditure (C), a function of real aggregate national income itself, planned real aggregate investment expenditure (I), a function of the rate of returns on investment (r), Government Expenditure (G) which is usually taken to be autonomously determined and finally net export demand (defined as the difference between export demand and import demand, i.e., X - M). Now, in the Keynesian framework, there is sufficiently excess capacity to ensure prices and wages are sticky in the short run and thus a fall in aggregate demands leads to a fall in output. This fall again dampens demand for consumption expenditure which in turn leads to reduced aggregate demand and in turn reduced real aggregate output. This mechanism continues and the real aggregate income goes on falling which is tantamount to a recession. Thus it emerges that a recession must be triggered by a fall in any of the components of effective aggregate demand. (Mankiw, 2002)
In fact a recession is a part of a business cycle that the economic growth of all advanced economies experiences. The idea of the business cycle is that the growth path of real aggregate output follows an oscillatory trend with the rise gradually moving onto a peak where after a reduction or contraction follows until it reaches a bottom and begins to move up once more. The movement towards the peak from the bottom or the trough is the period of expansion while the movement down from the peak to the trough is the period of recession. A period of recession is identified to be a depression if the real aggregate national income falls below the long run average trend. (McConnell & Brue, 2005)
The expansion of the economy is supported and sometimes facilitated by monetary expansion on part of the monetary authority. This includes measures such as reducing the rate of interest to induce higher investment demand. This boosts the aggregate demand thereby leading to an upward spiral of rising real aggregate income. However, as the demand for investment rises there is a rise in interest rates which increase the cost of production. Further the rise in incomes which motivates greater consumer spending, thereby lead to higher commodity prices. Increased demand to invest in financial assets leads to risen asset prices. All these factors combined lead to a fall in real aggregate demand and thus a slowing down of the economy thereby triggering the downward movement (Foldvary, 2007).
Often, to prevent or to restrict this downward movement, governments resort to expansionary monetary and fiscal policies to stimulate demands and motivate increased investment and consumer spending. As will be showed in what follows, the present