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