Chapter 2
ANSWERS TO QUESTIONS
1. If I can buy a car today for $5,000 and it is worth $10,000 in extra income to me next year
because it enables me to get a job as a traveling salesman, should I take out a loan from
Larry the Loan Shark at a 90% interest rate if no one else will give me a loan? Will I be
better or worse off as a result of taking out this loan? Can you make a case for legalizing
loan sharking?
2. Some economists suspect that one of the reasons economies in developing countries grow so
sense?
3. Why is a share of Microsoft common stock an asset for its owner and a liability for
Microsoft?
4. If you suspect that a company will go bankrupt next year, which would you rather hold,
bonds issued by the company or equities issued by the company? Why?
5. “Because corporations do not actually raise any funds in secondary markets, secondary
markets are less important to the economy than primary markets are.” Is this statement true,
false, or uncertain?
6. Describe who issues each of the following money market instruments:
a. Treasury bills
b. Certificates of deposit
c. Commercial paper
d. Repurchase agreement
e. Fed funds
7. What is the difference between a mortgage and a mortgage-backed security?
8. The U.S. economy borrowed heavily from the British in the nineteenth century to build a
9. A significant number of European banks held large amounts of assets as mortgage-backed
securities derived from the U.S. housing market, which crashed after 2006. How does this
demonstrate both a benefit and a cost to the internationalization of financial markets?
10. How does risk sharing benefit both financial intermediaries and private investors?
11. How can the adverse selection problem explain why you are more likely to make a loan to a
family member than to a stranger?
12. One of the factors contributing to the financial crisis of 2007–2009 was the widespread
issuance of subprime mortgages. How does this demonstrate adverse selection?
13. Why do loan sharks worry less about moral hazard in connection with their borrowers than
some other lenders do?
14. If you are an employer, what kinds of moral hazard problems might you worry about with
regard to your employees?
15. If there were no asymmetry in the information that a borrower and a lender had, could a
moral hazard problem still exist?
16. “In a world without information costs and transaction costs, financial intermediaries would
not exist.” Is this statement true, false, or uncertain? Explain your answer.
17. Why might you be willing to make a loan to your neighbor by putting funds in a savings
account earning a 5% interest rate at the bank and having the bank lend her the funds at a
10% interest rate, rather than lend her the funds yourself?
18. How do conflicts of interest make the asymmetric information problem worse?
19. How can the provision of several types of financial services by one firm be both beneficial
and problematic?
20. If you were going to get a loan to purchase a new car, which financial intermediary would
you use: a credit union, a pension fund, or an investment bank?
21. Why would a life insurance company be concerned about the financial stability of major
corporations or the health of the housing market?
22. In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the limit
on insured losses to bank depositors from $100,000 per account to $250,000 per account.
How would this help stabilize the financial system?
ANSWERS TO APPLIED PROBLEMS
23. Suppose you have just inherited $10,000 and are considering the following options for
investing the money to maximize your return:
Option 1: Put the money in an interest-bearing checking account that earns 2%. The
FDIC insures the account against bank failure.
town without repaying you.
Option 4: Hold the money in cash and earn zero return.
a. If you are risk-neutral (that is, neither seek out nor shy away from risk), which of the four
options should you choose to maximize your expected return? (Hint: To calculate the
expected return of an outcome, multiply the probability that an event will occur by the
outcome of that event.)
town without paying, would you pay the $100? What does this say about the value of
better information regarding risk?
This option implies the very real possibility of either receiving nothing (if he actually
ANSWERS TO DATA ANALYSIS PROBLEMS
1. Go to the St. Louis Federal Reserve FRED database, and find data on federal debt held by
the Federal Reserve (FDHBFRBN), by private investors (FDHBPIN), and by international
and foreign investors (FDHBFIN). Using these series, calculate the total amount held and
Repeat for the first quarter of 2000, and compare the results.
2014:Q1
2000:Q1
Held ($bil.)
% Share
Held ($bil.)
% Share
Fed
2319.6
12.5%
501.7
10.5%
Private Investors
10,300.0
55.5%
3182.8
66.7%
Foreign Investors
5949.4
32.0%
1085.0
22.7%
Total
18569.0
4769.5
2. Go to the St. Louis Federal Reserve FRED database, and find data on the total assets of all
financial intermediaries has experienced the most growth?
2013:Q4
2000:Q1
$13,929.9 Bil.
$5,639.2 Bil.
$2,678.3 Bil.
$1,664.8 Bil.