Final answer:
Low interest rates prior to the 2008 financial crisis led to increased borrowing and spending, particularly in the housing market, resulting in the creation of risky financial products and a housing bubble. When the bubble burst, these securities lost value, which contributed to the collapse of financial institutions and a global recession. Typically, low interest rates encourage risky lending and borrowing practices that can lead to economic dislocations if the underlying assets fail.
Step-by-step explanation:
Low interest rates played a significant role in the economic events leading up to the 2008 financial crisis. In a low-rate environment, borrowing becomes cheaper, which can lead to an increase in consumer spending and investment. However, excessively low rates for an extended period can lead to irresponsible lending and borrowing practices, as was the case in the prelude to the 2008 crisis. This was particularly evident in the housing market, where easy access to credit fueled a housing bubble.
As interest rates stayed low, financial intermediaries and institutions increased their lending, often to borrowers with poor credit histories. This led to a proliferation of subprime mortgages and the expansion of financial products tied to these risky loans, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). When housing prices began to fall and mortgage holders started to default, these securities lost value, contributing to the collapse of major financial institutions and a subsequent global recession.
Typically, low interest rates also encourage businesses to take on more debt to expand operations, but this comes with increased risk. If the market conditions deteriorate or if asset bubbles burst, those businesses may struggle to service their debt, potentially leading to defaults and a wider financial crisis. The situation is exacerbated if financial institutions themselves have high exposure to failing loans or if they are over-leveraged.