econ ch. 3 homework
Alternatively, if the price of the home decreases by 10%, your return is
-40%
Suppose you purchase a new home for $200,000, making a down payment of 25% and taking out a mortgage on the balance. If one year later the price of the home increases by 10%, the return on your investment in your home is
40%
Now assume that the liquidity premium theory is correct and that the term premium on the two-year bond is 0.50%. In this case, the expected interest rate on a one-year bond one year from now will be
5%
Finally, if the term premium on the three-year bond is 1.00%, the expected interest rate on a one-year bond two years from now is
5.5%
Suppose that today you observe the following interest rates on bonds with differing years to maturity: Assume that the expectations theory is correct, so that there is no term premium for a two-year bond or a three-year bond. From the information above, the expected interest rate on a one-year bond one year from now is
6%
Similarly, the expected interest rate on a one-year bond two years from now is
7.5%
Why can't the economy run in the "fast lane" if the financial system has "blown a gasket"?
A disruption in the flow of funds from lenders to borrowers (a "blown gasket") causes households and firms to cut spending, pushing the economy toward recession (no longer in the "fast lane").
What benefits does securitization of mortgage loans provide for banks? What benefits does securitization provide for people who want to buy a home?
Banks can expand the number of loans they make and to earn larger profits; therefore it makes more funds available for individuals who want to buy a home.
In what sense did the federal government "bailout" financial firms during the 2007-2009 financial crisis?
The Fed extended its role as a lender of last resort beyond commercial banks. The U.S. Treasury purchased stock in a large number of banks to increase banks' capital. The U.S. Treasury and the Fed facilitated the merger of several financial firms.
Why did the Federal Reserve allow Lehman Brothers to fail in 2008?
The Fed feared that assisting Lehman Brothers would increase the extent of moral hazard in the financial system.
Contrast the Fed's actions following the failure of the Bank of United States with its actions following the failure of Lehman Brothers.
The Fed intervened aggressively following the 2008 failure but remained largely inactive for several years following the 1930 failure.
An article in the New York Times in mid-2012 quoted an economist as saying, "The improvement in domestic credit conditions provides a further boost to the outlook for the economic recovery." Source: Alan Zibel and Jeffrey Sparshott, "Banks Ease Rules on Some Lending," Wall Street Journal, April 30, 2012. What are "domestic credit conditions"?
The cost and availability of loanable funds within a national economy.
Why would an improvement in domestic credit conditions provide a boost for the economy?
The pace of spending by households and firms would likely increase
Would your answer change if the interest rate was 18%?
Yes, the preferred choice is now $145 to be received in one year
Moral hazard occurs when:
actions people take after they have entered into a transaction make the other party worse off.
Nassim Nicholas Taleb, an economist at New York University, argued that employees of financial firms that might be bailed out by the federal government during a financial crisis should not be allowed to receive bonuses. According to Taleb, bankers receive "a bonus if they make short-term profits and a bailout if they go bust." He argues that banning bonuses will reduce the principal-agent problem that affects large financial firms. Source: Nassim Nicholas Taleb, "End Bonuses for Bankers," New York Times, November 7, 2011. The principal-agent problem is said to arise when:
an agent pursues his own interests rather than the interests of the principal who hired him.
A financial intermediary:
borrows funds from savers and lends them to borrowers.
The return on your investment changes with the size of your down payment since the computation of the former requires that the investment's capital gain (or loss) be _____ the down payment
divided by
Consider the graph of the money market to the right. For the following event, show the effect on the money market and then identify the change in the equilibrium nominal interest rate and the nominal money supply. The Fed decreases the money supply. The equilibrium nominal interest rate _____ and the nominal money supply _____.
increases, decreases
Given these data, why would an investor have been willing to buy a one-year Treasury bill with an interest rate of only 0.18% when the investor could have bought a 30-year Treasury bond with an interest rate of 2.59%?
An investor would expect interest rates on short-term bonds to be higher in the future. B. Investors are exposed to greater interest-rate risk when they buy long-term bonds versus buying short-term bonds. C. Most investors have a life expectancy for investing purposes of less than 30 years. D. A and B only. Your answer is correct. E. All of the above. Correct answer: D. A and B only
An Annual Report for the Federal Reserve Bank of Dallas contained the following observation: "For the most part, we take the financial system's routine workings for granted—until the machinery blows a gasket. Then we scramble to fix it, so the economy can return to the fast lane." Source: Federal Reserve Bank of Dallas, Annual Report, 2011, p. 7. Why might most people, including most policymakers, tend to take the workings of the financial system for granted?
Because in all but the rarest of circumstances the financial system functions reasonably well.
For each of the following transactions, identify whether a financial intermediary is involved and, if it is a market transaction, state whether it occurs in a primary or secondary market A bank makes a mortgage loan to a home buyer A bank sells a mortgage loan to Fannie Mae
Financial intermediary Financial intermediary
What does an improvement in domestic credit conditions mean?
Greater accessibility to credit and lower interest rates for borrowers.
How did the federal government's actions affect the extent of moral hazard in the financial system?
It increased the extent of moral hazard in the financial system, but the magnitude is uncertain.
Other than pooling deposits and making loans, which of the following are the three key services that financial intermediaries perform for savers and borrowers?
Risk sharing, liquidity, and information.
Why did the Federal Reserve allow the Bank of United States to fail in 1930?
The Fed did not want to be viewed as rewarding the poor business decisions of the bank's managers.
Securitization occurs when:
loans are bundled together into securities that are resold to investors.
An example of a financial intermediary is:
mutual funds. B. insurance companies. C. commercial banks. D. all of the above.
Adverse selection occurs when:
one party to a transaction takes advantage of knowing more than the other party
If Taleb's analysis is correct, banning paying bonuses might reduce the principal-agent problem by:
reducing the incentive that bankers have to take risks.
If your down payment had been 30% rather than 25%, the answers to the two previous questions would be
smaller in absolute value
When considering the situation of a large financial firm that might be bailed out by the federal taxpayers, in this case, the principal is the _____ and the agent is the _____.
taxpaying public, bank's managers and owners
The demand for money curve is downward sloping because at lower interest rates:
the opportunity cost of holding money is lower.
Both moral hazard and adverse selection problems occur when:
there is asymmetric information.
Assume that the interest rate is 9%. Would you prefer to receive: $145 one year from now, $160 two years from now, or $170 three years from now?
$160 two years from now