Money, Banking, and the Financial System (Hubbard/O’Brien)
Chapter 9 Transactions Costs, Asymmetric Information, and the Structure of the
Financial System
9.1 Obstacles to Matching Savers and Borrowers
1) Transactions costs are
A) zero in financial markets.
B) zero in financial intermediaries.
C) the costs of direct financial transactions.
D) equal to the taxes imposed on financial transactions.
2) Information costs
A) are the costs of buying and selling financial claims.
B) include the costs that savers incur to determine the credit worthiness of borrowers.
C) include the costs borrowers incur to discover the best investments to make with the money
they have borrowed.
D) are zero in financial markets, but high for transactions carried out through financial
intermediaries.
3) The presence of transactions costs and information costs
A) lowers the cost of funds to borrowers.
B) raises the cost of funds to borrowers.
C) raises the expected return to lenders.
D) increases the efficiency of the financial system.
4) The presence of transactions costs and information costs
A) lowers the cost of funds to borrowers.
B) raises the expected return to lenders.
C) lowers the expected return to lenders.
D) increases the efficiency of the financial system.
5) Which of the following is NOT an example of transactions costs?
A) High interest rates
B) Lawyers’ fees
C) Brokerage commissions
D) Minimum investment requirements
6) Small savers face
A) high transactions costs in financial markets.
B) low transactions costs in financial markets.
C) high transactions costs in financial intermediaries.
D) high information costs in financial intermediaries.
7) Small savers face
A) low transactions costs in financial markets.
B) high transactions costs in financial intermediaries.
C) low transactions costs in financial intermediaries.
D) low information costs in financial intermediaries, but high transactions costs.
8) Financial intermediaries emerged
A) to make loans to governments.
B) to provide a market for municipal bonds.
C) to reduce transactions costs for small savers and borrowers.
D) to reduce transactions costs for traders in stocks and bonds.
9) Transaction and information costs
A) benefit borrowers at the expense of savers.
B) benefit savers at the expense of borrowers.
C) transaction costs hurt savers while information costs hurt borrowers.
D) create profit opportunities for those who can reduce these costs.
10) Banks earn a profit by
A) charging savers and borrowers fees for reducing transactions costs.
B) holding large equity positions in major corporations.
C) holding large equity positions in small firms.
D) publishing ratings of corporate bonds.
11) Financial intermediaries reduce transactions costs by
A) charging fees to small savers.
B) charging fees to small investors.
C) taking advantage of economies of scale.
D) avoiding risky investments.
12) Economies of scale are
A) charges to savers and borrowers imposed by banks in exchange for reducing transactions
costs.
B) the reduction in costs per unit that accompanies an increase in volume.
C) decreases in transactions costs that occur as information costs increase.
D) decreases in information costs that occur as transactions costs increase.
13) Individual investors can reduce transactions costs by
A) buying common stock rather than bonds.
B) combining their purchases through an intermediary.
C) common stocks directly, rather than through a mutual fund.
D) making loans directly, rather than depositing funds in a bank.
14) Which of the following does NOT represent a way in which financial intermediaries take
advantage of economies of scale?
A) paying lower brokerage fees per dollar invested
B) paying lower legal fees per dollar invested
C) purchasing sophisticated computer systems
D) paying lower taxes per dollar invested
15) Financial intermediaries are able to exploit economies of scale since
A) the equipment or expertise necessary for one transaction can be applied to other transactions.
B) they have special licenses needed to perform financial transactions.
C) financial markets fail to do so.
D) they can reduce transactions cost, but not information costs.
16) The reduction in transactions costs brought about by financial intermediaries benefits
A) small savers, but not small borrowers.
B) small borrowers, but not small savers.
C) both small savers and small borrowers.
D) society through greater economic efficiency; small savers and borrowers do not gain directly.
17) What are the information costs faced by savers?
18) How are financial intermediaries able to reduce transactions costs?
19) What are the various ways that financial intermediaries can take advantage of economies of
scale?
9.2 The Problems of Adverse Selection and Moral Hazard
1) It is generally agreed that
A) the financial system would be more efficient if intermediaries were eliminated.
B) small- and medium-sized firms benefit by the actions of intermediaries.
C) the addition of intermediaries adds to transactions costs.
D) intermediaries should not seek to profit from reducing transactions costs.
2) Generally, when there is asymmetric information
A) a lender will only lend to the government.
B) a lender will only lend to well-known borrowers.
C) practical solutions are devised to allow lending to take place.
D) a lender will cease all lending activities.
3) The assumption of asymmetric information means that
A) borrowers and lenders have the same information.
B) borrowers and lenders have perfect information.
C) borrowers know more than lenders.
D) lenders know more than borrowers.
4) The company that manufactures Screaming Chocolate Zonkers breakfast cereal finds that its
sales collapse, it is forced into bankruptcy, and it defaults on its bonds, as a result of information
on the filthy conditions in its factory, which had long been known to management, leaking out to
the general public. This incident is best thought of as an example of
A) symmetric information in the financial markets.
B) asymmetric information in the financial markets.
C) moral hazard in the financial markets.
D) the generally poor state of sanitation in the food-processing industry in the United States.
5) Which of the following is NOT true of adverse selection?
A) It would not exist in a world of perfect information.
B) It arises because borrowers typically know more than lenders.
C) It describes a lender’s problem of distinguishing the good-risk applicants from the bad-risk
applicants.
D) It describes a lender’s problem in verifying borrowers are using their funds as intended.
6) Which of the following is NOT true of moral hazard?
A) It would not exist in a world of perfect information.
B) It arises because borrowers typically know more than lenders.
C) It describes a lender’s problem of distinguishing the good-risk applicants from the bad-risk
applicants.
D) It describes a lender’s problem in verifying borrowers are using their funds as intended.
7) Which of the following is an example of adverse selection?
A) A homeowner with a large fire insurance policy allows the wiring in her house to deteriorate.
B) A woman with a large life insurance policy takes up sky diving.
C) Your brother-in-law borrows $20,000 from you to open a pizza parlor, but spends it gambling
at the racetrack instead.
D) A man with a bad heart condition buys a large life insurance policy.
8) Which of the following is NOT an example of adverse selection?
A) A family with a home ten feet from a large river buys flood insurance.
B) A company uses the proceeds of a new stock sale to build an unnecessarily luxurious new
headquarters.
C) A terminal cancer patient buys life insurance.
D) A company in serious financial trouble offers to pay you 30% on a loan.
9) The “lemons problem” in the used car market arises from
A) the difficulty U.S. producers have in making reliable cars.
B) the difficulty buyers have in distinguishing good cars from lemons.
C) the tendency of buyers of used cars to pay for them with bad checks.
D) the reluctance of many car dealers to handle used cars.
10) The “lemons problem” exists in the market for goods because
A) sellers tend to try to take advantage of buyers.
B) buyers tend to try to take advantage of sellers.
C) differences in the quality of the goods being exchanged.
D) of moral hazard.
11) Which economist is credited with having been the first to discuss the “lemons problem”?
A) George Akerlof
B) Milton Friedman
C) Robert Shiller
D) James Tobin
12) The “lemons problem” is overcome in the used car market by
A) strict government regulation of private deals between individual buyers and sellers of used
cars.
B) most used cars selling for well below their true values.
C) “lemon insurance” policies being offered by insurance companies.
D) the existence of used car dealers who are concerned about maintaining their reputations.
13) You own a 2007 Ford Explorer. Although it has high mileage, you have maintained it very
well. You want to sell it, but after checking the prices other owners of 2007 Ford Explorers are
able to get for their cars in the used car market, you decide the prices are too low and you decide
not to sell. This is an example of
A) the “lemons problem.”
B) moral hazard.
C) economies of scale.
D) low information costs.
14) If there were no adverse selection problems in the stock market,
A) some well-run firms would pay more to raise funds.
B) some poorly-run firms would pay less to raise funds.
C) the willingness of savers to invest in the market would be increased.
D) the volume of new stock issues would be lower.
15) When interest rates in the bond market rise,
A) adverse selection problems increase.
B) adverse selection problems are mitigated.
C) moral hazard problems increase.
D) moral hazard problems are mitigated.
16) Why is adverse selection more likely in financial markets when interest rates rise?
A) The remaining borrowers are more likely to be risky.
B) Higher interest rates are likely to hurt the economy.
C) If firms have to pay higher interest rates, they may choose to use the funds differently than
they first intended.
D) Banks eliminate risky borrowers by raising interest rates.
17) To help offset the costs from loan defaults, the First National Bank of Gotham decides to
increase the interest rate it charges on its business loans. As a result of this increase in the
interest rate, the creditworthiness of Gotham’s loan applicants is likely to
A) improve.
B) deteriorate.
C) be unchanged.
D) be unchanged, unless the economy enters a recession at the same time as the interest rate is
increased.
18) Why do higher interest rates increase adverse selection problems in the loan market?
A) Higher interest rates reduce the gains from economies of scale.
B) As interest rates rise, the creditworthiness of the average loan applicant declines.
C) Higher interest rates reduce information problems in the loan market.
D) At higher interest rates fewer investment projects are profitable.
19) One method that lenders use to mitigate the adverse selection problem is to
A) charge higher interest rates to less creditworthy borrowers.
B) monitor closely the behavior of borrowers after a loan is made.
C) ration credit.
D) provide default insurance.
20) Credit rationing refers to
A) the increase in the interest rate that occurs when the demand for credit increases.
B) the increase in the interest rate that occurs when the supply of credit increases.
C) the increase in the interest rate that occurs when the supply of credit decreases.
D) a restriction in the availability of credit.
21) One reaction of firms to the adverse selection problem is to
A) rely on internal funds to finance investment.
B) use the stock market rather than the bond market to raise funds.
C) use the bond market rather than the stock market to raise funds.
D) borrow long-term rather than short-term.
22) All of the following are consequences of adverse selection on good firms EXCEPT
A) the cost of external financing increases.
B) firms need to rely more on internal funds.
C) firms need to rely more on accumulated profits.
D) firms will only be able to attain financing from the government.
23) Symmetric information
A) is the same as perfect information.
B) holds under the assumption of rational expectations.
C) is true only in efficient markets.
D) means that savers and borrowers have the same information.
24) When there’s asymmetric information, who tends to have the better information?
A) lender
B) borrower
C) intermediary
D) equally likely to be the borrower or the lender
25) Government regulations requiring firms that desire to sell securities in financial markets to
disclose all available information
A) eliminate the adverse selection problem (when rigorously enforced).
B) increase the difficulty that young firms may have in raising funds.
C) eliminate the moral hazard problem in securities markets.
D) fail to eliminate the adverse selection problem, in part because they do not greatly reduce the
difficulty that young firms have in raising funds.
26) Requirements for information disclosure for firms that desire to sell securities in financial
markets
A) are very common in industrialized countries, including the United States.
B) are common in other industrialized countries, but have not yet been adopted in the United
States.
C) have been adopted in the United States, but have not yet been adopted in other industrialized
countries.
D) have yet to be adopted in the United States or other industrialized countries.
27) Moody’s Investors Service is able to make a profit because
A) most investors are irrational.
B) of the existence of adverse selection problems.
C) fluctuations in interest rates make default risk on corporate bonds difficult to gauge.
D) small investors like the mutual funds they sell.
28) Which of the following is NOT a company that collects information on individual borrowers
and sells it to savers?
A) Moody’s Investor Service
B) Value Line
C) NASDAQ
D) Dun and Bradstreet