978-0134733821 Chapter 2 Solution Manual

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 58

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

slowly is that they do not have well-developed financial markets. Does this argument make

sense?

3. Give at least three examples of a situation in which financial markets allow consumers to

better time their purchases.

Examples of how financial markets allow consumers to better time their purchases include:

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?

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 60

productive uses. In this sense, both European banks and U.S. borrowers should have benefitted.

However, with the sharp decline in the U.S. housing market, default rates on mortgages rose

sharply, and the value of the mortgage-backed securities held by European banks fell sharply.

Even though the financial crisis began primarily in the United States as a housing downturn, it

significantly affected European markets; Europe would have been much less affected without

such 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?

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 63

ANSWERS TO APPLIED PROBLEMS

24. 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.

Option 2: Invest the money in a corporate bond with a stated return of 5%, although there

is a 10% chance the company could go bankrupt.

Option 3: Loan the money to one of your friend’s roommates, Mike, at an agreed-upon

interest rate of 8%, even though you believe there is a 7% chance that Mike will leave

town without repaying you.

Option 4: Hold the money in cash and earn zero return.

a. If you are risk-neutral (i.e., neither seek out nor shy away from risk), which of the four

a. With Option 1, since deposits are insured it can be assumed a riskless investment.

b. Option 3 implies the very real possibility of either receiving nothing (if he actually

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 64

information (not paying your roommate), you have a range of payoffs of $0 to

$10,800 versus $9900 to $10,700 without asymmetric information. Thus, paying a

small amount to improve risk assessment under Option 3 can be very beneficial, a

task for which financial intermediaries are well suited. Option 4, is riskless, so the

expected total payoff is $10,000. If you are more risk averse, Option 4 is likely the

better option. However, if you are more risk neutral then paying your roommate the

$100 to have a minimum $9900 payment and possibly as much as $10,700 is the

better scenario.

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 the

percentage held in each of the three categories for the most recent quarter available. Repeat

for the first quarter of 2000, and compare the results.

2017:Q1

2000:Q1

Held ($bil.)

% Share

Held ($bil.)

% Share

Fed

2859.1

13.7

501.7

10.5

Private Investors

11904.8

57.1

3182.8

66.7

Foreign Investors

6079.3

29.2

1085.0

22.7

Total

20843.2

4769.5

2. Go to the St. Louis Federal Reserve FRED database and find data on the total assets of all

commercial banks (TLAACBM027SBOG) and the total assets of money market mutual funds

(MMMFFAQ027S). Transform the commercial bank assets series to quarterly by adjusting

the Frequency setting to “Quarterly.” Calculate the percent increase in growth of assets for

each series, from January 2000 to the most recent quarter available. Which of the two

financial intermediaries has experienced the most growth?

Commercial Banks