Banking and Business
Briefly explain the theory of adaptive expectations and the theory of rational expectations.
Theory of adaptive expectations suggests that changes in expectations will occur slowly over time as past data change. Theory of rational expectations states expectations will be identical to optimal forecasts using all available information.
What crucial role do financial intermediaries perform in an economy?
They channel funds from people who have saved and in turn make loans to others.
Use demand and supply analysis to explain why an expectation of Fed rate hikes would cause Treasury prices to fall.
When expected inflation rises, the supply curve shifts from Bs1 to Bs2, and the demand curve shifts from Bd1 to Bd2. The equilibrium moves from point 1 to point 2, with the result that the equilibrium bond price falls from P1 to P2 and the equilibrium interest rate rises.
What is the impact on interest rates when the Federal Reserve decreases the money supply by selling bonds to the public?
When the equilibrium bond price moves downward, the equilibrium interest rate rises.
How does a mutual fund lower transactions costs through economies of scale?
A mutual fund is a financial intermediary that sells shares to individuals and then invests the proceeds in bonds or stocks. Because it buys large blocks of stocks or bonds, a mutual fund can take advantage of lower transaction costs.
How does collateral help to reduce the adverse selection problem in credit market?
Collateral, property promised to the lender if the borrower defaults, reduces the consequences of adverse selection because it reduces the lender's losses in the event of a default.
Would it make sense to buy a house when mortgage rates are 14% and expected inflation is 15%? Explain your answer.
Yes, because at the end of the year I will be ahead by 1% in real terms. The nominal rates do not allow for inflation. When inflation is subtracted from a nominal return, we have the real return, which indicates the amount of extra goods and services .
Explain how cigarettes could be called "money" in prisoner-of-war camps or prisons.
Money refers to anything that is generally accepted in payment for goods and services or in the repayment of debts and is distinct from income and wealth. The cigarettes are a medium of exchange.
Your favorite uncle advises you to purchase long-term bonds because their interest rate is 10%. Should you follow his advice?
No, because a rise in interest rates means that eh price of the bond has fallen and that a capital loss has occurred. If this loss is large enough, the bond can be a poor investment.
If the federal government were to raise the income tax rates, would this have any impact on a state's cost of borrowing funds (municipal bonds)? Explain.
No, because municipal bonds are exempt from federal income taxes.
Everything else held constant, would an increase in volatility of stock prices have any impact on the demand for rare coins? Why or why not?
Yes, because based on the risk relative to other assets if an asset's risk rises - which would be the stock - relative to that of alternative assets, its quantity demanded will fall.
What rights does ownership interest give stockholders?
the right to vote and to be the residual claimant of all funds flowing into the firm. They may receive dividends from the net earnings of the corporation.
What factors have slowed down the movement to a system where all payments are made electronically?
•It is very expensive to set up the computer, card reader, and telecommunications networks necessary to make electronic money the dominant form of payment. •Electronic means of payment raise security and privacy concerns. •The use of electronic means of payment leaves an electronic trail that contains a large amount of personal data on buying habits.
Identify and explain the three stages of a financial crisis
A.Initiation of Financial Crisis - which begins in several ways; mismanagement of financial liberalization/innovation, asset price booms and busts, or a general increase in uncertainty caused by failures of major financial institutions. B.Banking Crisis - deteriorating balance sheets and tougher business conditions lead some financial institutions into insolvency. When net worth becomes negative. Banks close because they can't pay back their depositors or other creditors. C.Stage deflation - a substantial unanticipated decline the price level sets in, leading to a further deterioration in firms net worth because of the increased burden of indebtedness.
From 1980-1985, the dollar strengthened in value against other currencies. Who was helped and who was hurt by this strong dollar?
American consumers benefited because it makes foreign goods cheaper. But it hurt American businesses and eliminated some jobs by cutting both domestic and foreign sales of their products.
The spread between the interest rates on Baa corporate bonds and U.S. government bonds is very large during the Great Depression years 1930-1933. Explain this difference using the bond supply and demand analysis.
An increase in default risk shifts the demand curve for corporate bonds left and shifts the demand curve for Treasury bonds to the right which raises the price Treasury bonds and lowers the price of corporate bonds, and therefore lowers the interest rate on Treasury bonds and raises the rate on corporate bonds, thereby increasing the spread between the interest rates on corporate versus Treasury bonds.
Distinguish between direct finance and indirect finance. Which of these is the most important source of funds for corporations in the United States?
Direct finance is where borrowers borrow funds directly from financial markets by selling securities. Indirect finance is where a financial intermediary borrows funds from lender-savers and then uses these funds to make loans to borrower-spenders. Indirect finance is the source of funds for corporations in the US.
What are the advantages and disadvantages of a bank specializing in making certain types of loans?
Disadvantage would be the bank is not diversifying it's portfolio of loans and thus is exposing itself to more risk. Advantage would be it's easier to collect comparable information on firms that are far away. By concentration these industries and is therefore better able to predict which firms will be able to make timely payment on their debt.
Typically, the economy recovers fairly quickly from a recession. Why did this not happen in the United States during the Great Depression?
Due to the continuing panic, failure of banks, stocks falling, and general decline in the economy the great depression spread worldwide. Foreign companies' sales declined in the U.S. due to the lack of demand which in turn cost foreign workers jobs. This led to World War II.
What happens to economic growth and unemployment during a business cycle recession? What is the relationship between the money growth rate and a business cycle recession?
During a business cycle recession economic growth is on the decline and the unemployment rate rises. Money growth rate has declined before almost every recession, indicating that changes in money might be a driving force behind business cycle fluctuations.
Why are most of the U.S. dollars held outside of the United States?
Foreigners hold more than half of U.S. dollars because they do not trust their own currency because they experience high inflation which erodes the value of that currency. These people hold U.S. dollars as a hedge against this inflation risk.
Given a balance sheet, demonstrate the effect an increase or decrease in interest rates will have on risk sensitive assets and liabilities and ultimately on a bank's net worth.
If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits. If interest rates go down our profits go up.
Describe the two methods of organizing a secondary market.
One method is to organize exchanges, where buyers and sellers of securities meet in one central location to conduct trades. The New York stock exchange for stocks and Chicago Board of Trade for commodities are examples of organized exchanges. The other method of organizing a secondary market is to have an over the counter (OTC) market, in which dealers at different locations who have an inventory of securities stand ready to buy and sell securities "over the counter" to anyone who comes to them and is willing to accept their prices.
Most "Experts" agree that the housing bubble was an immediate cause of the recession in 2007. But what caused the Housing Bubble? Summarize the opposing arguments of. Taylor and Bernanke.
Taylor argues that the low federal funds rate led to low mortgage rates that stimulated housing demand and encouraged the issuance of subprime mortgages, both of which led to rising housing prices and a bubble. Basically Taylor blamed the housing bubble on the Fed. Bernanke replied to this saying the fault was due to the proliferation of new mortgages, products that lowered mortgage payments, a relaxation of lending standards that brought more buyers into the market and capital inflows from emerging market countries.
Briefly explain the efficient market hypothesis.
The efficient market hypothesis states that current security prices will fully reflect all available information because in an efficient market, all unexploited profit opportunities are eliminated. The elimination of unexploited profit opportunities necessary for a financial market to be efficient does not require that all market participants be will informed.
Because there is an imbalance of information in a lending situation, we must deal with the problems of adverse selection and moral hazard. Define these terms and explain how financial intermediaries can reduce these problems.
occurs. Adverse selection in financial markets occurs when the potential borrowers who are the most likely to produce an undesirable (adverse) outcome - the bad credit risks are the ones who most actively seek out a loan and are thus most likely to be selected. Moral hazard is the problem created by asymmetric information after the transaction occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might engage in activities that are undesirable (immoral) from the lenders point of view, because they make it less likely that the loan will be paid back. Financial intermediaries have higher earnings on their investments than do small savers, because they are better equipped than individuals to screen out bad credit risks from good ones, thereby reducing losses due to adverse selection. In addition, financial intermediaries have high earnings because they develop expertise n monitoring the parties they lend to thus reducing losses due to moral hazard.
