(need expert help)

This topic has expert replies
Master | Next Rank: 500 Posts
Posts: 405
Joined: Thu Feb 10, 2011 1:44 am
Thanked: 3 times
Followed by:1 members

(need expert help)

by voodoo_child » Tue Oct 04, 2011 8:06 am
Source : Knewton

The real estate market and the recurring business cycles of the national economy at large are commonly believed to be deeply interdependent. Two models exist, based on the differing directions in which the economic cycle is moving. According to the first model, as a national economy expands, the income of many potential home buyers in metropolitan areas increases, as does the number of lenders offering mortgage loans. The increase in competition benefits the consumer; the increase in options for consumers forces lenders to decrease their rates to compete, which encourages even those whose incomes have not increased in proportion to the economy at large to seek home financing. That this is so is suggested by the economic principle dictating that a decrease in the cost of borrowing (in this case, mortgage interest rates) will result in a rapid increase in the number of borrowers. These additional home purchases are thought to provide vast influxes of taxable capital into the economy, helping it to expand further. Conversely, the second theory states that in an economic downturn, consumers, overcome with debt and lacking other avenues of credit, will default on their home equity loans, in which home value is used as collateral to borrow money. According to the theory, these defaults lead to a rise in the number of foreclosures and, thus, to a glut in the housing market as housing inventories rise, which decreases home prices for other homeowners. The crisis of confidence among homeowners, seeing home prices decrease, affects both those who provide mortgage loans as well as those who hold them, and the resultant decrease in spending can have a cataclysmic effect on the national economy.

Unfortunately, the first theory is not always accurate, especially in its presumption that mortgage interest rates will always decrease in response to an increase in the number of homeowners seeking mortgage loans. Alternatively, a rise in the demand for credit (in this case, home mortgages) can lead to a rise in the price of credit (mortgage interest rates). When it does, some potential homeowners may refuse or be unable to take out mortgage loans, which would restrict the expansion of the housing market and its corresponding effect on the national economy at large.

The second theory also relies on some problematic assumptions. The assertion that an economic downturn will force consumers to default on their home equity loans assumes the absence of other options by which consumers can receive credit; there is no reason to assume that an economic downturn will automatically lead to foreclosures. It must be admitted that, because many consumers fear the foreclosure of their homes, many panic in the face of a downturn, even if they have not used their homes as equity, and this panic can prompt a decrease in spending. However, such a reaction can be attributed to an ignorance of economic patterns, which is addressable through economic education, rather than to economic forces inherent to the business cycle.

Which of the following best summarizes the main idea of the passage?

(A) When the pool of potential homeowners increases, capital is added to the national economy, unless mortgage interest rates increase rather than decrease.

(B) Educating consumers about the true relationship between economic downturns and home foreclosures will decrease their likelihood to panic and worsen the downturn.

(C) Because most consumers and mortgage lenders believe that business cycles and real estate markets are interdependent, they make decisions that leave them exposed in economic downturns.

(D) Because the theories that connect real estate prices to business cycles contain unwarranted assumptions, the common belief that the two are interdependent in all cases is flawed.

(E) A rise in mortgage interest rates or in the number of credit sources available to consumers can eliminate the negative effects of the business cycle on the real estate market.

OA - D

I was suspicious about D because the author doesnt consider the two theories flawed. She says that the theories have "some problematic" assumptions or "not always accurate".

Any help please?

GMAT Instructor
Posts: 70
Joined: Thu Dec 16, 2010 3:22 pm
Thanked: 37 times
Followed by:18 members

by Ilana@EconomistGMAT » Wed Oct 05, 2011 4:31 am
Perhaps you need to reassess your understanding of the word "flawed". When something is flawed, this does not mean it is outright wrong or false, but that is has something wrong with it, whether slight or major. For the assumptions to be "problematic" or "not always accurate" is perfectly consistent with describing them as "flawed".