Macroeconomics: Policy and Practice, 2e (Mishkin)
Chapter 15 Financial Crises and the Economy
15.1 Asymmetric Information and Financial Crises
1) The notion that lenders must select from a pool of bad credit risks, because the most
undesirable borrowers are those that most actively seek out a loan is known as the ________.
A) moral hazard problem
B) ornamental torsion problem
C) adverse selection problem
D) asymmetric innovation problem
2) Channeling funds to individuals with productive investment opportunities is the function of
________.
A) the financial sector
B) state and local governments
C) the central bank
D) state, local and federal governments
3) The risk that a borrower has more information about their previous behavior than a potential
lender is known as the ________.
A) moral hazard problem
B) adverse selection problem
C) time-space discontinuity
D) tertiary behavior problem
4) The risk that a borrower has a greater understanding about their potential future behavior than
a potential lender is known as ________.
A) the problem of adverse selection
B) the problem of moral hazard
C) ornamental torsion
D) the asymmetric innovation problem
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5) Which of the following best illustrates the adverse selection problem?
A) a professional football team that consistently drafts poor players
B) an economic agent who engages in risky behavior once a loan is received
C) an individual who hides a pre-existing condition from a health insurer
D) an individual who experiences a lost of income by not working while attending college
6) Which of the following best illustrates the problem of moral hazard?
A) a professional baseball team that consistently drafts poor players
B) an individual that is hiding a pre-existing condition from a health insurance provider
C) an increase in the level of one’s income will lead to a decrease in demand for inferior goods
D) an economic agent that engages in risky behavior once a loan contract is signed
7) The analysis of asymmetric information problems is called ________.
A) adverse selection
B) microeconomics
C) cybernetics
D) agency theory
8) According to agency theory, a financial crisis results from ________ that disrupts the flow of
funds from lender-savers to borrower-spenders.
A) an increase in asymmetric information
B) a macroeconomic shock
C) the existence of asymmetric information
D) a decrease in saving
15.2 Dynamics of Financial Crises
1) Financial institutions that cut back on their lending are engaged in ________.
A) liability management
B) deleveraging
C) financial innovation
D) torsion control
2) The main objective of financial liberalization is ________.
A) to encourage financial innovation
B) to improve the allocation of financial capital
C) to discourage volatility in financial markets
D) to reduce the likelihood of a credit boom
3) Prior to World War II, in the United States, financial crises occurred every ________ years or
so.
A) twenty
B) seven
C) fifty
D) three
4) In the period from 1929 through 1933, there were successive ________ in aggregate demand
and ________ in short-run aggregate supply.
A) increases; decreases
B) decreases; increases
C) decreases; no change
D) increases; increases
5) The failure of a major financial company is often a trigger for a financial crisis. The main
reason for trouble at a single firm to become a crisis for the entire economy is that ________.
A) the central bank will suspend operations until the failed firm is restructured
B) it is unclear whether the firm’s collapse will remain an isolated event
C) customers of the failed company will organize a boycott to protest their losses
D) employees and owners of the failed company reduce their spending, with adverse effects on
other businesses
6) An early sign that financial innovation might be leading toward a financial crisis is ________.
A) deleveraging
B) a bank panic
C) a credit boom
D) debt deflation
7) The adverse consequences of debt deflation are most evident ________.
A) in the expansion of credit to high-risk borrowers
B) on the balance sheets of nonfinancial businesses
C) in a sharp decline in the real interest rate
D) on the balance sheets of financial businesses
8) ________ refers to a decrease in the willingness of banks to lend, while an impairment of the
ability of nonfinancial firms to borrow is a consequence of ________.
A) Adverse selection; moral hazard
B) Deleveraging; debt deflation
C) Fire sales; a bank panic
D) The shadow banking system; agency theory
9) A rapid increase in the availability of credit to previously underserved borrowers is likely
________.
A) to result from financial liberalization
B) to improve the allocation of capital
C) to confirm the merits of microcredit
D) to result from deleveraging
10) A likely consequence of deposit insurance, ceteris paribus, is ________.
A) an increase in risk-taking by banks
B) a bank panic
C) a credit boom
D) a reduction in the severity of adverse selection
11) When banks fail during a financial crisis, ________.
A) the removal of these weak institutions serves to strengthen the financial system
B) the elimination of competitors is likely to spark a credit boom
C) there is a loss of information that can cause the crisis to worsen
D) surviving banks resort to financial engineering to retain customers
12) Assume that a firm has $100 million in real assets and $90 in real liabilities. The value of its
net worth would be ________.
A) a negative $10 million.
B) $190 million.
C) $4190 billion.
D) $10 million.
13) Assume that a firm has $100 million in real assets and $90 in real liabilities. If the price level
rise by ten percent, the real value of its assets would ________.
A) fall
B) rise
C) change, but more information must be provided to determine their exact movement
D) remain unchanged
14) Assume that a firm has $100 million in real assets and $90 in real liabilities. If the price level
falls by ten percent, the real value of liabilities would ________.
A) fall to $81 million
B) change, but more information must be provided to determine the exact movement
C) remain unchanged
D) rise to $99 million
15) An asset-price bubble entails ________.
A) increasing the value of one’s assets to cover liability losses
B) an increase in asset prices above their fundamental economic value
C) reducing the number of participants in the underlying financial derivatives market
D) an economic skins game
16) The main reason that many businesses fail when the price level is falling is that ________.
A) deflation causes a decline in short-run aggregate supply
B) as prices fall, businesses are unable to predict the quantity of output they will be able to sell
C) the real value of the firms assets declines in proportion to the decrease in the price level
D) falling prices mean that regular loan payments become increasingly difficult
17) When banks and other financial institutions become insolvent, ________.
A) the problem of asymmetric information becomes more acute
B) it is easier to distinguish the good creditors and borrowers from the bad
C) surviving creditors will attract borrower-spenders by lowering the real interest rate
D) the resulting increase in short-run aggregate supply will discourage investment
18) U.S. financial crises begin in a period of ________.
A) rising incomes
B) adverse selection
C) rising uncertainty
D) moral hazard
19) An individual firm is insolvent when ________.
A) its assets exceed the value of its liabilities
B) its average costs per unit are greater than its marginal cost
C) its average costs per unit are less than its marginal cost
D) its liabilities exceed the value of its assets
20) The decline in net worth that can result from an unanticipated decline in the price level is
known as ________.
A) a credit boom
B) deleveraging
C) a debt deflation
D) federal funds rationing
21) Which of the following statements is correct?
A) assets plus liabilities equal net worth
B) liabilities plus net worth equal assets
C) assets plus net worth equal liabilities
D) liabilities minus net worth equal assets
22) The most severe financial crisis in U.S history occurred in the years ________.
A) 2006-2008
B) 1997-98
C) 1929-33
D) 1873-93
23) A prominent aspect of the Great Depression of the 1930s, but not of the recent Great
Recession, is ________.
A) bank panics
B) mortgage defaults
C) an increase in the credit spread
D) nonconventional monetary policy
24) A prominent aspect of the recent Great Recession, but not of the Great Depression of the
1930s, is ________.
A) bank panics
B) mortgage defaults
C) an increase in the credit spread
D) nonconventional monetary policy
25) An increase in the general level of prices will tend to cause, other things the same ________.
A) an increase in the real value of assets
B) an increase in the real value of liabilities
C) no change in the real value of liabilities
D) a decrease in the real value of liabilities
26) The Great Crash on the New York Stock Exchange occurred in ________.
A) October 1929
B) July 1776
C) September 2001
D) March 1933
27) President Franklin Delano Roosevelt declared a bank holiday, closing all U.S. banks in
________.
A) July 1776
B) October 1929
C) March 1933
D) September 2001
28) The difference between the interest rate on loans to households and firms and the rate on
completely safe assets is known as ________.
A) the discount rate
B) the FICO score
C) the credit spread
D) the prime rate
29) The credit spread refers to ________.
A) the extent to which financial instruments are distributed among households at different
income levels in a given society
B) the difference between the London Inter-Bank Offered Rate (LIBOR) and the fed funds rate
C) the price elasticity of household debt
D) the interest-rate differential between risky bonds and U.S. Treasury bonds
30) Most likely, the stock market crash in 1929 was triggered by ________.
A) an autonomous tightening of monetary policy
B) an unexpected increase in tax rates
C) the rise of fascist political parties in Europe
D) a decline in consumer spending
31) In the Great Depression, investment spending fell by ________.
A) nine-tenths of one percent
B) nine percent
C) ninety percent
D) nine hundred percent
32) The Great Depression ________.
A) was largely confined to the United States
B) was largely confined to European markets
C) was largely confined to Asian markets
D) was worldwide in scope
33) During the Great Depression, as real interest rates rose, good credit risks were less likely to
seek loans. This process illustrates the phenomenon of ________.
A) adverse selection
B) moral hazard
C) poor monetary policy
D) debt deflation
34) Subprime borrowers ________.
A) are those individuals who owe more on their mortgage than the value of their home
B) possess a relatively low FICO score
C) rely on mortgage-backed securities to support their mortgage applications
D) are those with an income level below the value of their mortgage
35) The financial innovation of numerical credit scoring contributed to the ________.
A) “democratization of credit”
B) reduction of loan-to-value ratios
C) “depersonalization of credit”
D) reduction of information asymmetries
36) Financial innovations may be expected to cause a decline in ________.
A) financial frictions
B) the credit spread
C) the real interest rate on investments
D) all of the above
E) none of the above
37) Financial innovations may be expected to cause a decline in ________.
A) aggregate demand
B) asset prices
C) the real interest rate on investments
D) all of the above
E) none of the above
38) Financial innovations may be expected to cause a decline in ________.
A) the ability of lenders and borrowers to fully understand the latest financial opportunities
B) the ability of government regulators to foresee emerging threats to financial stability
C) incentives for financial intermediaries to avoid high-risk loans
D) all of the above
E) none of the above
39) Instruments which provide payments to holders of bonds in the event of default are known as
________.
A) collateralized bond obligations
B) tertiary payment devices
C) credit default swaps
D) mortgage-backed securities
40) The practice of approving mortgages in order to sell them as mortgage-backed securities is
known as ________.
A) originate-to-distribute
B) principal-agent engineering
C) predatory lending
D) a credit default swap
41) Hedge funds, investment banks, and other non-depository financial firms are known as
________.
A) the shadow banking system
B) repurchasers
C) subprime lenders
D) CDOs
42) If the value of a home falls below the amount owed on the mortgage for that property, the
house is said to be ________.
A) underwater
B) collateralized
C) swamped
D) in short sale
43) A haircut (in finance) is ________.
A) the payment of a block of funds as part of a refinancing arrangement
B) the percentage by which the value of collateral exceeds the value of the loan
C) the issue of equities rather than debt in acquiring access to money capital
D) the immediate end of lending to subprime borrowers
44) A $100 million loan with a haircut of four percent requires collateral valued at ________.
A) $104 million
B) $96 million
C) $4 million
D) $400,000
45) From 1995-2007, the Irish economy ________.
A) suffered from severe unemployment, famine and labor migration
B) witnessed a boom in the real economy, but suffered through a collapse in asset prices
C) enjoyed one of the highest growth rates in the world
D) suffered through a period of prolonged deflation
46) The worst weekly decline in U.S. stock market history occurred during the week beginning
with ________.
A) March 20, 1933
B) December 7, 1941
C) September 12, 2001
D) October 6, 2008
47) An increase in asymmetric information that increases financial frictions will tend to
________.
A) increase the moral hazard and adverse selection problems in credit markets
B) decrease financial frictions
C) improve market efficiency
D) decrease the moral hazard problem
48) The most direct and important consequence of an increase in asymmetric information
problems is ________.
A) a decrease in the probability of loan repayment
B) inability to assess the probability of loan repayment
C) unwillingness of borrowers to accept the market rate of interest
D) inability of creditors to acquire enough funds to meet borrowers’ demand
49) The financial market events of September and October 2008 ________.
A) sparked a sharp widening of the credit spread
B) signalled the success of the policy response to the financial crisis
C) reduced some of the uncertainty that had paralyzed financial markets
D) resulted from the federal funds rate having fallen below zero
50) How is a financial crisis like a power blackout?
51) Describe the role of uncertainty at the beginning of and in the unfolding of a financial crisis.
52) How can improvements in statistical analysis of financial data cause the amount of
information in financial markets to decline?
53) What are the effects of a financial crisis on short-run aggregate supply? How might long-run
aggregate supply be affected?
54) How might the globalization of financial markets affect the role of financial frictions in
business fluctuations?
15.3 Why the 2007-2009 Financial Crisis Did Not Lead to a Depression
1) The rate targeted by the Federal Reserve System as it conducts monetary policy is the
________.
A) discount rate
B) prime rate
C) Treasury bill rate
D) fed funds rate
2) Which of the following is among the possible reasons that the 2007-2009 financial crisis did
not result in an economic depression?
A) the declaration of a bank holiday by the nation’s President
B) international policy coordination
C) strict reliance on conventional monetary policy
D) government spending restraint
3) Which of the following is among the possible reasons that the 2007-2009 financial crisis did
not result in an economic depression?
A) tax cuts
B) elimination of nonessential government spending
C) rapid prosecution of predatory lenders
D) closure of the shadow banking system
4) Which of the following is among the possible reasons that the 2007-2009 financial crisis did
not result in an economic depression?
A) new lending programs by the central bank
B) privatization of Fannie Mae and Freddie Mac
C) a substantial increase in exports to China
D) rapid foreclosure of “underwater” properties
5) Monetary policy in the United States is primarily the responsibility of ________.
A) the President and Congress
B) the Federal Reserve System
C) the U.S. Treasury
D) the Comptroller of the Currency
6) Fiscal policy involves the manipulation of ________.
A) U.S. interest rates
B) wages and prices
C) federal government spending and tax revenues
D) the supply of money
7) The key objective of purchases by the Federal Reserve of over $1 trillion worth of debt issued
by private firms was ________.
A) to avoid the bankruptcy of the issuing firms
B) to manage expectations
C) to prevent such firms from being acquired by foreign companies
D) to stimulate spending by firms and households
8) The zero-lower-bound problem eliminates the ability of the central bank to use which of the
following in implementing policy?
A) open market operations
B) discount lending
C) the federal funds rate
D) the required reserve ratio
9) In the event that nominal short-term interest rates cannot be lowered further, the Federal
Reserve might rely on ________.
A) federal government fiscal policy
B) targeting the fed funds rate
C) quantitative easing
D) targeting the inflation rate
10) Attempts by a central bank to increase bank deposits without a decrease in nominal short-
term interest rates are referred to as ________.
A) quantitative easing
B) credit channeling
C) open market operations
D) liquidity provision
11) Management of expectations by a central bank is based on the view that ________.
A) decreasing the federal funds rate will lead to a reduction in the discount rate
B) if economic agents believe that the price of an individual asset will rise in the future, they will
buy that asset today, contributing to its eventual price increase
C) if households expect an increase in prices in the future, they will engage in spending today
D) households will increase their spending today if they believe that the monetary authorities are
committed to maintaining low interest rates
12) In an attempt to manage expectations, a central bank may prefer to announce an
unconditional commitment, because an unconditional commitment ________ than a conditional
commitment.
A) is inherently more credible
B) may have an impact on expectations that is stronger
C) places fewer constraints on policy makers
D) is less likely to have unintended consequences
13) The most important component of the Economic Recovery Act passed by the Bush
Administration was ________.
A) the creation of the Federal Reserve discount window
B) the establishment of the Troubled Asset Relief Program (TARP)
C) the decrease in taxes for the wealthiest one percent of all Americans
D) the creation of the Federal Reserve
14) The Troubled Asset Relief Program ________.
A) led to the creation of the Federal Reserve System
B) helped contribute to the stock market crash of 2006-2007
C) shifted non-performing assets off the balance sheet of the Federal Deposit Insurance
Corporation onto the balance sheet of Fannie Mae and Freddie Mac
D) authorized the Treasury to by mortgages from troubled financial institutions
15) The Economic Recovery Act of 2008 included a temporary increase in the federal deposit
insurance ceiling from $100,000 to $250,000. The likely objective was to ________.
A) boost bank profitability
B) increase the money supply
C) discourage withdrawals from banks
D) bail out the Federal Deposit Insurance Corporation (FDIC)
16) Following the collapse of its housing and stock markets around 1990, the Japanese
government ________.
A) effectively managed the crisis, limiting the damage to the Japanese economy
B) took only limited action in response to the crisis
C) was able to rely on private initiatives in quickly reversing the course of GDP in the 1990s
D) fixed the value of the yen to the Euro and pursued an aggressive monetary policy
17) Central bank lending to bail out troubled firms is known as ________, while allowing
troubled firms to conceal the true value of their assets is called ________.
A) crony capitalism; larceny
B) liquidity provision; regulatory forbearance
C) securitization; nonconventional monetary policy
D) subprime lending; regulatory arbitrage
18) Compared to the central bank response to the financial crisis in 2007-2009, the response to
the Great Depression of the 1930s may be characterized as ________, while the response of
Japan’s central bank to the banking crisis in the early 1990s merits the label ________.
A) hasty; sluggish
B) intrusive; tenacious
C) complacent; indulgent
D) corrupt; technocratic
19) Why is responding to a financial crisis by bailing out financial institutions more effective
than direct support of nonfinancial businesses?
20) How did international policy coordination contribute to the avoidance of an economic
depression in 2008 – 2010?
21) Describe how a central bank can increase aggregate demand by influencing expectations.
15.4 Policy Response to Asset-Price Bubbles
1) Asset-price bubbles ________.
A) are a relatively recent phenomenon
B) end with an increase in asset prices
C) have been a feature of market economies for centuries
D) are likely to be prevented by advances in computer technology and telecommunications
2) Asset-price bubbles ________.
A) impact the macroeconomy only when they burst
B) are easily recognized by market participants
C) always involve overly optimistic expectations
D) are unlikely to occur when credit is readily available
3) Credit-driven bubbles ________.
A) occur exclusively within the financial sector
B) are more likely to be identified by central bank officials than by market participants
C) are best contained with a policy of high real interest rates
D) are harder to identify than expectations-driven bubbles
4) Which of the following is a distinctive feature of a credit-driven asset-price bubble?
A) asset-price increases that are “justified” by projections of future value
B) a weakening of lending standards
C) an increase in the number and variety of market participants
D) The affected assets are financial stocks or bonds issued by companies in the financial sector.
5) The key reason that the bursting of the tech-stock bubble of the late 1990s had a mild impact
on the macroeconomy is ________.
A) rapid intervention by the central bank averted economic catastrophe
B) the increase in tech-stock prices was driven by the economic fundamental of technological
progress
C) the technology sector is a rather small portion of the aggregate economy
D) tech-stock prices had not been much influenced by credit availability
6) Regulatory policy used to affect credit markets is known as ________.
A) fiscal restraint
B) monetary policy
C) Bierstadt relaxation
D) macroprudential regulation
7) How is asymmetric information related to asset-price bubbles?
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8) What is the argument against the use of autonomous tightening of monetary policy in response
to a credit-driven asset-price bubble?
9) How does macroprudential regulation relate to conventional measures to prevent fraud and
promote transparency?