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business
principles of macroeconomics

Questions and Answers of Principles Of Macroeconomics

7. List the four broad categories of financial reform. Describe a proposed reform in each category and explain how it would help prevent a financial crisis.
6. Is the following statement true or false? Explain your answer. “The only costs of financial QUESTIONS FOR REVIEW rescues are the direct payments from the government.”
5. Why are some financial institutions “too big to fail” and what are the implications for central bank and government policy?
4. How can the central bank or government prevent failures of insolvent financial institutions or reduce the costs of failures to the economy?
3. Explain how the central bank can ease liquidity crises at solvent financial institutions.
2. Explain how a financial crisis leads to a fall in aggregate demand and a recession.
1. What two types of events are the typical triggers for financial crises?
14. Go to the Web site of the Office of the Comptroller of the Currency and look up“enforcement actions.” Find an example of a specific enforcement action against a bank.Explain what the OCC did
13. Many states allow payday lending but impose restrictions on the practice. For example, a state may limit the amount someone can borrow or the number of times a loan can be rolled over.Find out
12. Consider two possibilities: (i) A bank is forced to close even though there is no good reason for it to close; (ii) A bank remains open even though there are good reasons for it to close.a.
11. Consider an analogy (the type on the SATs): “A bank regulator is to a bank as a bank is to a borrower.” In what ways is this analogy true? LOP8
10. Some economists suggest that banks should be charged premiums for deposit insurance based on their levels of capital. Premiums should be higher if capital is lower. What is the rationale for this
9. Suppose an economy has a high level of loans from one bank to another. How might this fact affect the likelihood of a bank panic? LOP8
8. Suppose you are a depositor at Duckworth’s Bank, which has the balance sheet shown in Table 18-2. Deposit insurance does not exist.You originally deposited your money in Duckworth’s because
b. What is the bank’s return on equity? LOP8
a. What is the bank’s return on assets? LOP8
7. Suppose a bank has $200 million in assets,$10 million in profits, and $40 million in capital. LOP8
How do you think this fact affects the types of mortgages offered by Canadian banks? (Hint:Think about interest rate risk.) LOP8
6. Canada does not have institutions like Fannie Mae and Freddie Mac that securitize mortgages. LOP8
b. What deal could the company make with a bank to reduce interest rate risk for both parties? LOP8
a. How does the company’s rate-sensitivity gap differ from those of most banks? LOP8
5. Suppose Hibbard’s Finance Company raises most of its funds by issuing long-term bonds. It uses these funds for floating-rate loans. LOP8
b. After the loan sale, what additional transactions is the bank likely to make? What will the balance sheet look like after these transactions?PROBLEMS AND APPLICATIONS LOP8
a. What is the immediate effect on the balance sheet? LOP8
4. Suppose that Duckworth’s Bank starts with the balance sheet in Table 18-2. Then the bank sells$10 of loans for $10 of cash. LOP8
b. How would you respond to these arguments if you oppose kneecap breaking? LOP8
a. Suppose you were hired as a lobbyist for the loan sharks. What arguments could you make to support their proposal? LOP8
3. Suppose that loan sharks propose legislation to promote their industry. They want a legal right to break the kneecaps of loan defaulters. LOP8
2. Securitization has spread from mortgages to student loans, auto loans, and credit-card debt.However, few loans to businesses have been securitized, except for loans guaranteed by the
1. HSBC has $1 trillion in assets and operates in about 100 countries. It calls itself “the world’s local bank.” What business strategies does this phrase suggest? Why might these strategies be
10. What are the main ways in which regulators try to prevent banks from misusing depositors’ funds? LOP8
9. Explain how deposit insurance works, the reasons that governments provide deposit insurance, and the problems that deposit insurance can create. LOP8
8. What is interest rate risk? How does a bank limit its exposure to interest rate risk? LOP8
7. What is credit risk? How does a bank limit its exposure to credit risk? LOP8
6. If a bank has $100 million in assets and $80 million in liabilities, what is the bank’s net worth? LOP8
5. Define the major items on the assets and liabilities sides of a bank’s balance sheet.QUESTIONS FOR REVIEW LOP8
4. What are Fannie Mae and Freddie Mac? What are their links to the government in the past and at present? LOP8
3. Explain the process of how loans undergo securitization. LOP8
2. Identify the four types of subprime lenders and explain how each one deals with the higher default risk of subprime loans. LOP8
1. Describe the similarities and differences between commercial banks and savings institutions. LOP8
10. One part of bank regulation is supervision and monitoring of banks’ activities. Banks must file quarterly call reports on their finances and submit to on-site examinations at least once a year.
9. U.S. banks are heavily regulated by a variety of federal and state agencies.Regulators seek to reduce the risk of bank failure by restricting the riskiness of banks’ assets and by requiring
8. Bankers have incentives to misuse deposits by taking on excessive risk or by looting. Deposit insurance exacerbates this moral hazard problem because it reduces depositors’ incentives to monitor
7. Deposit insurance, a promise by the government to compensate depositors if a bank fails, prevents bank runs because it makes depositors confident that their money is safe. LOP8
6. A bank run occurs when depositors lose confidence in a bank and make sudden, large withdrawals. A run can cause a previously healthy bank to fail. It can result from self-fulfilling expectations:
5. Banks face credit risk, which they seek to reduce by screening and monitoring borrowers and by demanding collateral. They also face interest rate risk, which they limit through loan sales,
4. The left side of a bank’s balance sheet shows its assets, including reserves, securities, and loans. The right side shows the bank’s liabilities, including deposits and borrowings, and its net
3. Many bank loans, especially home mortgages, are securitized. Securitization increases the funds available for loans and allows banks to eliminate default risk on their loans. LOP8
2. People with low incomes or poor credit histories borrow from subprime lenders, including subprime finance companies, payday lenders, pawnshops, and illegal loan sharks. LOP8
1. Types of banks—institutions that make loans and accept deposits—include commercial banks, savings institutions, and credit unions. Finance companies make loans but do not accept deposits. LOP8
11. Do you know someone (such as a parent) who is working and saving for retirement? Does he or she have money in a 401(k) plan? What securities does the person hold through the plan? Does he or she
10. Go to www.planetrating.com, the site of Planet Rating, an organization that calls itself “the global microfinance rating agency.” What is the main function of Planet Rating? How might its
9. Microfinance institutions argue that (a) many traditional banks discriminate against women in lending and (b) women have lower default rates than men on loans from MFIs. Discuss how point (a)
8. When a bank makes a loan, it sometimes requires borrowers to maintain a checking account at the bank until the loan is paid off.What is the purpose of this requirement? LOP8
7. National credit bureaus collect information on people’s credit histories. They are likely to know whether you ever defaulted on a loan. Suppose that a new privacy law makes it illegal for credit
6. Firms such as Moody’s and Standard & Poor’s study corporations that issue bonds. They publish “ratings” for the bonds—evaluations of the likelihood of default. Suppose these rating
5. A company raises funds by issuing short-term bonds (commercial paper) and uses the funds to make private loans. Such a firm is called a finance company. Is a finance company a type of bank? LOP8
4. Suppose there are two investors. One has a project to build a factory; the other has a project to visit a casino and gamble on roulette. Which investor has a greater incentive to issue bonds?Which
3. If you were required to put all your retirement savings in the securities of one company, what company would you choose, and why? Would you choose the company you work for? Would you buy stock or
2. Suppose the owner of a corporation needs$1 million to finance a new investment. If his total wealth is $1.2 million, would it be better to use his own funds for the investment or to issue stock in
1. When financial markets channel funds from savers to investors, who benefits? Explain. LOP8
10. Why have centrally planned economies failed? LOP8
9. Why is a healthy financial system important for economic growth? LOP8
How might the bank solve this problem? LOP8
8. Ned wants a $10,000 loan from Capital One to open a sushi bar, but he filed for bankruptcy eight years ago. What type of asymmetric information problem does this example illustrate? LOP8
7. Jennifer wants to get a loan from Citizens Bank to open a hair salon, but she is sometimes tempted to visit local casinos. What type of asymmetric information problem does this example illustrate?
6. What is moral hazard? How do banks reduce this problem? LOP8
5. What is adverse selection? How do banks reduce this problem?QUESTIONS FOR REVIEW LOP8
4. What is asymmetric information, and why is it a problem in financial markets? LOP8
3. What is the difference between a bond and a stock? LOP8
2. What are the two main functions of the financial system? LOP8
1. What is a security? LOP8
3. The Social Security system levies a tax on workers and pays benefits to the elderly. Suppose that Congress increases both the tax and the benefits.PROBLEMS AND APPLICATIONS For simplicity, assume
2. Draft a letter to the senator described in Section 14-3, explaining and evaluating the Ricardian view of government debt. LOP8
8. Why might the level of government debt affect the government’s incentives regarding money creation? LOP8
7. Give three reasons why a budget deficit might be a good policy choice. LOP8
6. Do you find more credible the traditional or the Ricardian view of government debt? Why? LOP8
5. According to the Ricardian view of government debt, how does a debt-financed tax cut affect public saving, private saving, and national saving? LOP8
4. According to the traditional view of government debt, how does a debt-financed tax cut affect public saving, private saving, and national saving? LOP8
3. Describe four problems affecting measurement of the government budget deficit. LOP8
2. Why do many economists project increasing budget deficits and government debt over the next several decades? LOP8 QUESTIONS FOR REVIEW
1. What was unusual about U.S. fiscal policy from 1980 to 1995? LOP8
d. What happens to the real interest rate in the short run and in the long run? (Hint: Use the model of the real interest rate in Chapter 3 to see what happens when output changes.) LOP8
c. According to Okun’s law, what happens to unemployment in the short run and in the long run? LOP8
b. What happens to the level of output and the price level in the short run and in the long run? LOP8
a. What happens to the aggregate demand curve? LOP8
2. Suppose the Fed reduces the money supply by 5 percent. LOP8
e. If the goal of the Fed is to stabilize output, how would your answer to part (d)change? LOP8
d. If the goal of the Fed is to stabilize the price level, should the Fed keep the money supply constant in response to this regulatory change? If not, what should it do? Why? LOP8
c. If the Fed keeps the money supply constant, what will happen to output and prices in the short run and in the long run? LOP8
b. What happens to the velocity of money?PROBLEMS AND APPLICATIONS LOP8
a. How does this change affect the demand for money? LOP8
1. An economy begins in long-run equilibrium, and then a change in government regulations allows banks to start paying interest on checking accounts. Recall that the money stock is the sum of
5. Why is it easier for the Fed to deal with demand shocks than with supply shocks? LOP8
4. Explain the impact of an increase in the money supply in the short run and in the long run. LOP8
3. Why does the aggregate demand curve slope downward? LOP8
2. Give an example of a price that is sticky in the short run but flexible in the long run. LOP8
1. When real GDP declines during a recession, what typically happens to consumption, investment, and the unemployment rate? LOP8
6. Shocks to aggregate demand and aggregate supply cause economic fluctuations. Because the Fed can shift the aggregate demand curve, it can attempt to offset these shocks to maintain output and
5. In the short run, the aggregate supply curve is horizontal, because wages and prices are sticky at predetermined levels. Therefore, shifts in aggregate demand affect output and employment. LOP8

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