Suggested Answers of BT2 Revision Package - ASKnLearn

(b)Explain how a rise in interest rate and the bursting of the UShousing bubble resulted in the economic crisis for US.The economic crisis in US is caused by subprime mortgage crisis thatresulted in lower national income in US. The subprime mortgage crisisitself is caused by higher interest rates and the bursting of the UShousing bubble as stated in Extract 4.As mentioned in Extract 4, the US central bank has increased theinterest rates from 1% to 5.25%. A rise in the interest rate will increasethe cost of borrowing as the interest cost will increase for a givenamount borrowed. Therefore consumption and investment will fall asthey are negatively related to interest rate and AD will fall resulting inlower national income in US. [1]Bursting of the US housing bubble caused prices of housing to fall.Furthermore, the increasing defaults and foreclosures have led to areduced supply of new loan as US housing mortgage companies areless willing and able to lend. Extract 4 pointed out that many housingmortgage companies are forced to shutdown. These have two effectson the US economy. First, with a fall in housing prices the wealth ofhouse owners will decrease and hence lowering autonomousconsumption. Second, there will be less investment on housing as lessnew loans are offered. AD will fall due to a fall in C and I henceresulting in lower national income in US. [2]Cap at [2] if there is no supporting evidence from the case orexplanation is provided only for 1 factor.[3](c)With the aid of a diagram, explain how the subprime crisis mayaffect China’s economy in the long-term.The subprime crisis would affect China’s economy in the long-termthrough its effect on trade.As stated in Extract 4, if the subprime crisis exacerbates and results insevere economic downturn in US and EU, consumption spending willfall and hence imports from China will fall. This will lead to a fall in Xand hence decreases the AD of China in the longer term. Inventorieswill increase and lead to a fall in production, output, employment andnational income through the multiplier. This can be seen in the AD-ASdiagram below.[5]