1. Does the problem of moral hazard indicate that insolvent banks should not be rescued?Justify your answer.

2. What are the three key characteristics of systemic banking crises? How would you expect these characteristics to influence the IS curve?

6.Using the housing market as an example, explain the following concepts:

(a) loan-to-value ratio;

(b) asset price bubble;

(c) financial accelerator.

7.Imagine an investment bank which has equity of 1 0 and operates in an economy where risk is0.15, the policy rate is 0, the rate of return on financial assets is 0.05 and the price offinancial assets is I. Use Section 6.5 to answer the following questions:

(a) How many financial assets does the investment bank hold in period 0? What is their

leverage?

(b) In period 'I, risk falls to 0.04 and price of financial assets rises to 1.03. What happens to the IB's leverage and holdings of financial assets?

(c) In period 2, the IB marks to market its financial assets. How much does this increase their equity? How many financial assets do they hold at the end of this period?

(d) In the next period risk rises back towards its initial level. Calculate how much asset prices need to fall to bankrupt the IB. What does this tell us about the dangers of leverage in the banking system?

9. What is a balance sheet recession? What factors make these recessions more difficult to recover from than normal recessions? Illustrate a balance sheet recession in the 3-equation model.

10.Discuss the following statement: 'central banks can offset the fall in borrower demand in a balance sheet recession by reducing interest rates and inducing savers to spend more'. Illustrate your answer using the 3-equation model.