Many borrowers defaulted on subprime mortgages ultimately disrupting financial markets by August 2007.Which of the following is a likely result of this increase in financial frictions?
A)The AD curve likely shifted left which caused a negative output gap.
B)The AD curve likely shifted left causing a negative inflation gap.
C)The AD curve likely shifted left followed by an downward movement along the MP curve to a lower equilibrium interest rate in the short run.
D)all of the above
E)none of the above

Question

Quizplus · Accepted Answer

The increase in financial frictions due to the default on subprime mortgages would likely lead to a decrease in aggregate demand (AD), as borrowing becomes more difficult and expensive, reducing spending and investment. This shift to the left in the AD curve could cause a negative output gap, indicating that actual output is below potential output. It could also lead to a negative inflation gap if the decrease in demand reduces pressure on prices. Additionally, the shift in the AD curve could be followed by a downward movement along the monetary policy (MP) curve to a lower equilibrium interest rate in the short run, as central banks might lower interest rates to stimulate the economy. Therefore, all of the mentioned effects are likely results of the increase in financial frictions.

Many Borrowers Defaulted on Subprime Mortgages Ultimately Disrupting Financial Markets