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Solutions to the End-of-Chapter Questions, Problems, and Data
Exercises
12.1 The Origins of Financial Crises
Learning objective: Explain what financial crises are and what causes them.
Review Questions
1.2 A bank run is the process by which depositors who have lost confidence in a bank
1.4 Currency crises can occur when a pegged (or fixed) exchange rate ends up substantially above or
Some European countries have been suffering from a sovereign debt crisis because they
experienced recessions and financial crises during 2007-2009 and beyond that increased
Problems and Applications
1.5 a. A contagion of fear means that a run or failure of one bank or several banks can cause depositors
b. Because FDIC insurance did not exist in the early 1930s, if a bank failed, then depositors would
c. The bank panics started in agricultural areas but the fear that causes bank runs quickly spread to
1.6 a. Exposure to counterparties reflects the risk of engaging in debt contracts or derivative contracts
b. Trading derivatives over the counter is less transparent than trading derivatives on an exchange,
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Chapter 12 Financial Crises and Financial Regulation 144
1.7 If a bank failed it would have 100% of the deposits on hand, so there would be no possibility of
1.8 A common deposit insurance system in the euro zone would reduce the fears that countries such
Additionally, a common deposit insurance system across the euro zone would insure deposits in
euros. Insuring deposits in euros would reduce the fear that countries would drop out of the euro
1.9 A recession that includes a financial crisis is generally has more severe consequences, such as
1.10 Similar to what Reinhart and Rogoff did, you could gather data on periods in the United States
1.11 a. Any banking system might face “implosion” because: 1) banks do not hold 100% reserves
b. The risk of “contagion across sovereign debt markets” means if one country defaults on its
bonds (and possibly drops out of the euro zone) then investors holding the bonds of other euro
1.12 Bank depositors were not afraid that banks would fail but that their bank deposits in euros would
be exchanged at a rate of one to one for deposits in their pre-euro domestic currencies (for
12.2 The Financial Crisis of the Great Depression
Learning objective: Understand the financial crisis that occurred during the Great Depression.
Review Questions
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Chapter 12 Financial Crises and Financial Regulation 145
2.1 Bank panics made the Great Depression more severe. Bank failures wiped out some of the
2.2 As a result of bank runs, banks were forced to sell assets, causing the prices of these assets to
decline. The decline in the prices of these assets caused other banks and investors holding these
2.3 Power within the Federal Reserve was much more divided than today making it more difficult for
the Fed to act. The Fed was reluctant to rescue insolvent banks, believing that doing so would
Problems and Applications
2.4 The Great Depression began in August 1929—two months before the October 1929 stock market
crash. President Hoover did not foresee the bank panics that would magnify the severity of the
2.5 a. Bank lending is “information sensitive” because banks acquire information to decide if
b. “Nonbank forms of credit” refer to credit from providers other than banks. For example, buyers
c. Yes; when thousands of banks failed, it became difficult for their customers to obtain credit,
2.6 a. Liquidate means to let prices fall to their equilibrium level and to let firms go out of business.
b. The Treasury Secretary’s policy advice at the beginning of the Great Depression helps to explain
the Fed’s actions to an extent because the Fed was acting on the predominant economic model of
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Chapter 12 Financial Crises and Financial Regulation 146
2.7 a. Interest payments on bonds are fixed nominal payments, so deflation increases the real
b. The nominal interest rates would be lower than the real interest rates. The real interest rate is the
2.8 a. Easy money policy means a policy of increasing the money supply and lowering interest rates.
b. No. Because of the deflation, real interest rates were high. In the Fed’s view, low nominal
interest rates indicated that there was an adequate supply of excess reserves to be used to cover
2.9 a. The Bank of United States was located in New York City and was one of the largest banks in the
b. Friedman and Schwartz argue that the Bank of United States was so large and so well-known
c. There are counterarguments to Rolnick’s view. Some economists argue that the failure of the
However, because Friedman and Schwartz’s argument was so influential, Rolnick may well be
12.3 The Financial Crisis of 2007-2009
Learning Objective: Understand what caused the financial crisis of 2007-2009.
Review Questions
3.1 A bubble means that an asset’s price has increased far beyond the asset’s fundamental value.
During the housing bubble many lenders granted mortgages to subprime and Alt-A borrowers.
These mortgages were bundled into mortgage-back securities (MBS), collateralized debut
obligations (CDOs), and similar securities, and sold to investors. Once housing prices started to
3.2 Investment banks borrow short term, particularly in the repo market, and lend some of the funds
long term. When repo borrowers refuse to roll over their loans, the banks must liquidate assets to
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Chapter 12 Financial Crises and Financial Regulation 147
3.3 The Federal Reserve: 1) lowered the federal funds rate to almost zero, 2) helped JPMorgan
Chase acquire Bear Stearns, and 3) began buying commercial paper issued by nonfinancial
Problems and Applications
3.4 a. A house price bubble is when house prices move beyond their fundamental values, which can be
b. Because when households purchase houses, they borrow at the mortgage interest rate, which is a
Chapter 5, long-term interest rates are typically significantly higher than short-term interest
c. Greenspan has been criticized for helping to cause the housing bubble by—along with his
3.5 a. Investment bank Bear Stearns almost failed because lenders lost faith in the bank’s ability to pay
b. In March 2008, the Federal Reserve arranged a buyout of Bear Stearns by JP Morgan Chase, a
c. A debt-deflation process would occur if Bear Stearns went bankrupt and had to sell its assets.
3.6 The Treasury and the Fed could not find a buyer for Lehman Brothers, and Lehman Brothers
Treasury allowed Lehman to fail because they worried that bailing out Lehman would have
Lehman’s managers had made. Some consider this the biggest mistake of the crisis because
3.7 a. Shadow banks are not regulated to the extent that commercial banks are. In particular, many
b. In order to compensate for the risk shadow banks faced, Greenspan believes that shadow banks
12.4 Financial Crises and Financial Regulation
Learning Objective: Discuss the connection between financial crises and financial regulation.
Review Questions
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4.1 The lender of last resort seeks to stop a bank failure from turning into a bank panic by making
4.2 Innovations to circumvent deposit-rate ceilings included the development of negotiable CDs,
4.3 Because deposits are insured, banks can focus on increasing the spread between the rates at
which they borrow and lend. Banks can increase the riskiness of their loans and investments
Problems and Applications
4.4 a. Regulatory capital requirements are the minimum amounts of capital that banks are required by
4.5 a. A hedge fund’s trades moving against it means that hedge fund has placed a bet that the price of
b. Hedge funds are usually highly leveraged, so a relatively small adverse movement in the prices
d. Dumping its positions means a hedge fund is selling the securities it owns, or the derivative
e. Prices of assets the fund holds would become destabilized. If a hedge fund owns a large amount
4.6 a. Debt leverage means borrowing and purchasing assets with the borrowed funds.
4.7 Some financial firms might have an advantage if they were already operating in ways that the
CFPB is now mandating, particularly if complying with the regulations involves costs that the
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Chapter 12 Financial Crises and Financial Regulation 149
4.8 a. Then Treasury Secretary Paulson wanted Bear Stearns to sell for a low price because he it was
b. Ordinarily, the federal government does not intervene to save firms on the brink of failure. In a
The decision was controversial to some economists and policymakers because they believed that
Data Exercises
D12.1
The unemployment rate generally goes down just before a recession, goes up during a recession, and goes
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Chapter 12 Financial Crises and Financial Regulation 150
D12.2
a. The interest rate on the Baa-rated corporate bonds generally goes down just before a
b. The pattern during the 2007-2009 recession for the interest rate on the Baa-rated corporate bonds
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