Econ/Fin 3313 Chapter 9

In what ways is the market for rental apartments like the market for used​ cars?

In both​ markets, the owner knows more than the potential renter or buyer.

If we lived in a world in which everyone was perfectly​ honest, would the difference in the transactions costs faced by financial intermediaries when they make loans and those faced by small savers when they make loans​ disappear?

No; while information costs might decrease there are still significant legal and other transaction costs involved in matching savers and borrowers.

What is the most important method of debt financing for​ corporations?

The bond market.

What is the most important source of funds for small to​ medium-sized firms?

The​ owners' personal funds and profits

If everyone were perfectly​ honest, would there be a role for financial​ intermediaries?

Yes

If insurance companies are correct in their​ suspicion, it will ____ the price of insurance.

increase

The World Bank measures financial development​ by:

the total amount of credit banks and financial markets extend to households and firms as a percentage of GDP.

Which of the following is not a reason why savers with small amounts to invest rarely make loans directly to individuals or​ firms?

The interest rate that savers would earn from making these loans is too low.

Just before the​ Covid-19 pandemic began to significantly affect the Chinese​ economy, two articles in the Wall Street Journal noted problems in the Chinese banking system. One article noted that large​ "Chinese banks also prefer to make safe loans to​ large, state-owned companies instead of helping the kind of​ small, private companies that are truly in​ need." Another article noted that smaller Chinese banks were having difficulty attracting deposits and were also experiencing rising levels of debt defaults. Are these problems likely to matter for the future growth of the Chinese​ economy?

Yes, small private businesses provide a lot of the​ jobs, innovation, and capital accumulation needed for a country to grow​ long-term. Only lending to large​ state-owned firms will limit growth.

Financial intermediaries take advantage of economies of scale​, which refers to the ____ in average cost that results from ____ in the volume of a good or a service produced.

economies of scale; reduction; an increase

Decades​ ago, many bank records were written by hand in ledgers. At the​ time, banks achieved _____ economies of scale as the amount of labor required to maintain such records was _____ for every​ transaction, _____ of the size of the bank. The shift to keeping all records on computers has _____ the opportunities to achieve economies of scale by replacing ____ costs with ______ costs.

little; the same; regardless increased; labor; technology

All of the following are reasons why these financial foundations were important in making possible the rapid growth of the U.S. economy during the nineteenth and twentieth​ centuries, except:

A central bank provided direct control over all interest​ rates, facilitating the control and direction of the overall economy.

An article in the Economist magazine​ observes: ​"Insurance companies often suspect the only people who buy insurance are the ones most likely to​ collect." ​Source:​ "The Money​ Talks," Economist​, December​ 5, 2008. What do economists call the problem being described​ here?

Adverse selection.

The author of a newspaper article providing advice to renters observes that​ "landlords will always know more than you​ do." ​Source: Marc​ Santora, "How to Be a Brainy​ Renter," New York Times​, June​ 3, 2010. Do you agree with this​ statement? If​ so, what do landlords know that potential renters might​ not?

Agree; Landlords know more about the quality of the​ property, and hence its true​ value, than renters.

Describe some of the information problems in the financial system that lead firms to rely more heavily on internal funds than external funds to finance their growth. Do these information problems imply that firms are able to spend less on expansion than is economically​ optimal?

Asymmetric information makes information costs for external funds higher than for internal​ funds, but these costs do not necessarily imply that firms are able to spend less on expansion than is economically optimal.

Which of the following is a correctly explained key feature of the financial​ system? ​(Check all that​ apply.) A) Debt contracts usually require collateral or restrictive covenants. The purpose of the collateral is to reduce adverse selection. B) Debt contracts usually require collateral or restrictive covenants. The purpose of the collateral is to reduce moral hazard. C) The stock market is a less important source of external funds to corporations than is the bond market. This is because there is less moral hazard involved with bonds than with stocks. D) The bond market is a less important source of external funds to corporations than is the stock market. This is because there is less moral hazard involved with stocks than with bonds. E) Trade credit is the most important external source of funds for​ small- to​ medium-sized firms. Trade credit can reduce the transaction costs of borrowing for small firms. F) Loans from financial intermediaries are the most important external source of funds for​ small- to​ medium-sized firms. Financial intermediaries can reduce the transaction costs of borrowing for small firms.

B) Debt contracts usually require collateral or restrictive covenants. The purpose of the collateral is to reduce moral hazard. C) The stock market is a less important source of external funds to corporations than is the bond market. This is because there is less moral hazard involved with bonds than with stocks. F) Loans from financial intermediaries are the most important external source of funds for​ small- to​ medium-sized firms. Financial intermediaries can reduce the transaction costs of borrowing for small firms.

Consider the possibility of income insurance. With income​ insurance, if a person loses his job or​ doesn't get as big a raise as​ anticipated, he would be compensated under his insurance coverage. Why​ don't insurance companies offer income insurance of this​ type? ​(Check all that​ apply.) A) The problem is moral hazard​ (people who are more likely to be fired or get low raises would be more likely to buy such​ insurance). B) The problem is adverse selection​ (people who are more likely to be fired or get low raises would be more likely to buy such​ insurance). C) This type of insurance would be unpopular among workers. D) The problem is adverse selection​ (once insured, you​ won't work as​ hard). E) The problem is moral hazard​ (once insured, you​ won't work as​ hard).

B) The problem is adverse selection​ (people who are more likely to be fired or get low raises would be more likely to buy such​ insurance). E) The problem is moral hazard​ (once insured, you​ won't work as​ hard).

If the article is correct about what was happening in the Chinese banking​ system, what problems might arise as a​ result?

Banks will make riskier and riskier loans over time.

In the adjacent​ figure, countries that are above the upward sloping line have relatively high levels of real GDP per capita for their levels of financial development and countries that are below the line have relatively low levels of real GDP per capita for their levels of financial development. Holding constant all other factors that might affect a​ country's rate of economic​ growth, would we expect future growth rates to be higher for countries above the line or for countries below the​ line?

Below the line because these countries have underperformed so far given the strength of their financial system.

Which of the following might explain why a country without a strong financial system would struggle to achieve high rates of economic​ growth?

Firms are unable to acquire funds they need to expand.

The World​ Bank's data tells us that countries with higher levels of financial development tend to have _____ levels of real GDP per​ capita, which indicates they are _____ able to provide a high standard of living for their residents.

Higher, better

If the statement is​ correct, what are the implications for the market for rental​ apartments?

Landlords will attempt to charge a higher price than they otherwise would receive in the absence of this information asymmetry.

What is the most important source of external funds for these​ firms?

Loans from financial intermediaries

Economist Richard Sylla of New York University has argued that in the​ 1790s, Secretary of the Treasury Alexander Hamilton "established the financial foundations that would make the United States the most successful emerging market in the nineteenth​ century, and the economic colossus of the next that some would call the​ 'American ​century.'" ​Source: Richard​ Sylla, "Financial ​Foundations: Public​ Credit, the National​ Bank, and Securities ​Markets," in Douglas A. Irwin and Richard​ Sylla, eds., Founding​ Choices: American Economic Policy in the 1790s​, ​Chicago: University of Chicago​ Press, 2011, p. 86. Sylla would focus on all of the following "financial foundations" of the United​ States, except:

The issuance of currency.

In what ways is it​ different?

The landlord is not selling the​ apartment, merely renting​ it, while the buyer of a used car makes an irreversible deal.

Why​ don't these firms rely on external funds to the same extent as large firms​ do?

Transactions costs and information costs are much higher for smaller firms.

An article in the Wall Street Journal discussed the fact that the Chinese government often intervenes to keep banks that make many bad loans from failing. The result was​ "moral hazard, or​ risk-taking based on the belief that someone else will pick up the tab if things go​ wrong." Do you agree with the​ article's definition of moral hazard in this​ context? This _____ of moral hazard because the article mentions that the government often intervenes to bail out banks making bad​ loans, therefore, banks are ____.

is an example; taking risks knowing they will not bear the entire burden when loans fail

What is the difference between venture capital firms and private equity​ firms? A _____ firm raises equity capital to acquire shares in established firms with the intention of reducing _____ problems. A ____ firm is a firm that raises equity capital from investors to invest in startup firms.

private equity; moral hazard; venture capital