Deck 20: The Financial System: Opportunities and Dangers

Question 1

Ownership claims by shareholders in a firm are called:

A) stocks.
B) bonds.
C) leverage.
D) debt.

Answer 1

stocks.

Question 2

Issuing bonds is called _____ financing, while issuing stocks is called _____ financing.

A) debt; equity
B) equity; debt
C) capital; investment
D) private; public

Answer 2

debt; equity

Question 3

A dislike of randomness in economic circumstances is called:

A) rational expectations.
B) risk aversion.
C) adverse selection.
D) moral hazard.

Answer 3

risk aversion.

Question 4

Equity financing is obtaining funds for a business by:

A) borrowing.
B) issuing ownership shares.
C) seigniorage.
D) government subsidy

Question 5

Debt financing is obtaining funds for a business by:

A) borrowing.
B) issuing ownership shares.
C) seigniorage.
D) government subsidy

Question 6

The financial system refers to the:

A) mechanism that transfers wealth from consumers to corporations.
B) institutions that facilitate the flow of funds between savers and investors.
C) arrangements that allow money to circulate in the economy.
D) government regulations that govern the terms of borrowing and lending.

Question 7

The allocation of resources between those who want to save and those who want to borrow is accomplished through:

A) the velocity of money.
B) fiscal policy.
C) the financial system.
D) foreign trade.

Question 8

All of the following are examples of financial intermediaries except:

A) commercial banks.
B) stock exchanges.
C) pension funds.
D) insurance companies.

Question 9

A bond (or debt instrument) is a(n):

A) ownership claim by the shareholder of a firm.
B) loan to a firm.
C) ongoing relationship between customers and a firm.
D) legal restriction on products a firm may produce.

Question 10

Stocks are:

A) loans to a firm.
B) assets minus liabilities of a firm.
C) leverage in a firm.
D) shares of ownership in a firm.

Question 11

Financial markets allow households to _____ provide resources for investment, while financial intermediaries allow households to _____ provide resources for investment.

A) directly; indirectly
B) indirectly; directly
C) productively; unproductively
D) unproductively; productively

Question 12

Funds flow directly between savers and investors in financial _____ and flow indirectly between savers and investors through financial _____.

A) stocks; bonds
B) intermediaries; markets
C) bonds; stocks
D) markets; intermediaries

Question 13

Financial markets allow savers to:

A) eliminate risk.
B) indirectly provide resources for investment.
C) directly provide resources for investment.
D) avoid adverse selection.

Question 14

A document representing an interest-bearing debt of the issuer, usually a corporation or government, is called:

A) equity.
B) stock.
C) a bond.
D) capital.

Question 15

Purchasers of bonds issued by companies are _____ of the company, while purchasers of shares of stock issued by a company are _____ of the company.

A) creditors; debtors
B) debtors; creditors
C) creditors; partial owners
D) partial owners; debtors

Question 16

Obtaining funds for a business by issuing ownership shares, such as through the stock market, is called _____ finance.

A) money
B) liability
C) debt
D) equity

Question 17

Risk aversion is a dislike of:

A) paying interest.
B) lending.
C) borrowing.
D) randomness in economic circumstances.

Question 18

The set of institutions in the economy that facilitates the flow of funds between savers and investors is called the:

A) financial system.
B) Federal Reserve system.
C) World Bank.
D) fiscal system.

Question 19

Obtaining funds for a business by borrowing, such as through the bond market, is called _____ finance.

A) money
B) liability
C) debt
D) equity

Question 20

Institutions that stand between savers and investors, helping to direct financial resources to their best use are called:

A) financial markets.
B) financial intermediaries.
C) financial regulators.
D) financial capitalists.

Question 21

Governments can reduce the problem of adverse selection by:

A) requiring disclosure about investment projects and a firm's finances.
B) providing loans from public funds.
C) keeping interest rates low.
D) reducing corporate income tax rates.

Question 22

Mutual funds that buy a diversified pool of assets can:

A) eliminate all risk.
B) eliminate systematic risk.
C) reduce idiosyncratic risk.
D) reduce systematic risk.

Question 23

Banks help mitigate the problem of adverse selection in lending by:

A) developing expertise in evaluating the business prospects of loan applicants.
B) making loans to many different types of borrowers.
C) adjusting the amount of the loan to fit the requirements of the borrower.
D) monitoring the business after a loan is made to the business.

Question 24

When a borrower uses borrowed funds to engage in activities that are detrimental to the profitability of the business venture that was financed, there is a problem of:

A) adverse selection.
B) moral hazard.
C) systematic risk.
D) risk aversion.

Question 25

Diversification allows savers to largely eliminate:

A) risk aversion.
B) idiosyncratic risk.
C) systematic risk.
D) risk premiums.

Question 26

Adverse selection may cause lenders to be offered opportunities to finance only:

A) the most desirable business ventures.
B) less desirable business ventures.
C) risk-free business ventures.
D) diversified business ventures.

Question 27

A well-functioning financial system does all of the following except:

A) foster economic growth by directing savings to its most productive use.
B) allocate risk among market participants.
C) eliminate risk through diversification.
D) direct resources from savers to borrowers.

Question 28

Which of the following is an example of adverse selection?

A) The careful driver buys extra insurance protection when renting a car.
B) The sickest people buy health insurance.
C) The person with health insurance rides a motorcycle without wearing a helmet.
D) The person with life insurance exercises daily and eats healthy foods.

Question 29

When the borrower has more knowledge about the attributes of an investment project than the lender, then the lender has a problem of:

A) adverse selection.
B) moral hazard.
C) risk aversion.
D) systematic risk.

Question 30

The Grameen Bank is:

A) the central bank of Bangladesh.
B) a lender of last resort.
C) a lending microfinance institution.
D) a subsidiary of the World Bank.

Question 31

Adverse selection concerns hidden knowledge about _____, while moral hazard concerns hidden knowledge about _____.

A) systematic risk; idiosyncratic risk
B) attributes; actions
C) equity finance; debt finance
D) financial markets; financial intermediaries

Question 32

Risk that affects many businesses at the same time is called _____ risk, while risk associated with individual businesses is called _____ risk.

A) asymmetric; symmetric
B) symmetric; asymmetric
C) systematic; idiosyncratic
D) idiosyncratic; systematic

Question 33

Reducing risk by holding many imperfectly correlated assets is called:

A) diversification.
B) moral hazard.
C) risk aversion.
D) leveraging.

Question 34

Two types of problems that arise due to asymmetric information are:

A) systematic and idiosyncratic risk.
B) risk aversion and diversification
C) illiquidity and insolvency.
D) moral hazard and adverse selection.

Question 35

Financial intermediaries that sell shares to savers and use their funds to buy diversified pools of assets are called:

A) pension funds.
B) insurance companies.
C) mutual funds.
D) commercial banks.

Question 36

Governments can reduce the problem of moral hazard by:

A) requiring licenses be obtained before starting a business.
B) prosecuting fraud and malfeasance.
C) keeping interest rates low.
D) reducing corporate income tax rates.

Question 37

Which of the following is an example of moral hazard?

A) The healthiest people buy life insurance.
B) The sickest people buy health insurance.
C) The person with health insurance rides a motorcycle without wearing a helmet.
D) The person with life insurance exercises daily and eats healthy foods.

Question 38

Banks help mitigate the problem of moral hazard in lending by:

A) requiring lengthy applications for loans.
B) making loans to many different types of borrowers.
C) adjusting the amount of the loan to fit the requirements of the borrower.
D) monitoring the business after a loan is made to the business.

Question 39

A situation in which one party to an economic transaction has more knowledge about the transaction than the other is called:

A) risk aversion.
B) asymmetric information.
C) systematic risk
D) learning by doing.

Question 40

The risk that imperfectly monitored agents will act in dishonest or otherwise inappropriate ways is called:

A) adverse selection.
B) moral hazard.
C) systematic risk.
D) risk aversion.

Question 41

The precipitous fall in the price of assets that takes place when financial institutions must sell their assets quickly in the midst of a crisis is called a(n):

A) insolvency.
B) subprime sale
C) speculative bubble.
D) fire sale.

Question 42

A rise in the price of an asset above its fundamental value is called a(n):

A) financial panic.
B) insolvency.
C) liquidity crisis
D) speculative bubble.

Question 43

The asset price that experienced a boom prior to the 2008-2009 recession was the price of:

A) oil.
B) residential real estate.
C) technology stocks.
D) food.

Question 44

A major disruption in the financial system that impedes the economy's ability to intermediate between those who want to save and those who want to borrow and invest is called a:

A) moral hazard.
B) speculative bubble.
C) financial crisis.
D) stagflation.

Question 45

The TED spread is the difference between the interest rate paid on _____ and the interest rate paid on _____.

A) three-month U.S. certificates of deposit; three-month eurodollar loans
B) overnight interbank loans in London; overnight interbank loans in the United States
C) four-week Treasury bills; overnight federal funds
D) three-month eurodollar interbank loans; three-month Treasury bills

Question 46

A credit crunch reduces aggregate demand by:

A) increasing the exchange rate.
B) increasing interest rates.
C) reducing consumption and investment spending.
D) reducing the money supply.

Question 47

The housing price boom prior to the 2008-2009 recession was fueled by all of the following except:

A) unusually large increases in building material costs.
B) lax lending standards.
C) government policies promoting homeownership.
D) homebuyers' expectations of never-declining home prices.

Question 48

The TED spread is an indicator of :

A) expected defaults in the mortgage market.
B) expected inflation.
C) worries about the solvency of the banking system.
D) the ease or tightness of monetary policy.

Question 49

An indicator of the increased lack of confidence in the banking system during the financial crisis of 2008-2009 was the:

A) increase in the federal government budget deficit.
B) decrease in interest rates.
C) increase in the TED spread.
D) decrease in the TED spread.

Question 50

If banks fear failure and become more conservative in making loans, then the sharp decline in bank lending is called a credit:

A) crunch.
B) hazard.
C) bubble.
D) swap.

Question 51

In the credit crunch during the 2008-2009 recession, banks tightened lending standards:

A) only for mortgages.
B) only for small business loans.
C) only for consumer loans.
D) for mortgages, small business loans, and consumer loans.

Question 52

One avenue by which a loss of confidence in one financial institution spreads to another financial institution is through:

A) a steep decline in asset prices driven by fire sales to restore liquidity.
B) a sharp decline in interest rates to compensate for added risk.
C) an increase in government deposit-insurance coverage.
D) a rapid slowdown in the withdrawal of deposits.

Question 53

An asset-price bubble bursts if there is:

A) a panic cycle of asset sales and falling asset prices.
B) a statement from the central bank stating that the bubble is over.
C) an excess demand for an asset that raises asset prices.
D) a sharp decrease in interest rates that pricks the asset-price bubble.

Question 54

The effect of the financial crisis of 2008-2009 on the real economy in the United States was a(n) _____ in aggregate demand, a(n) _____ in output, and a(n) _________ in the unemployment rate.

A) increase; increase; increase
B) decrease; decrease; decrease
C) decrease; increase; increase
D) decrease; decrease; increase

Question 55

Common elements of financial crises include:

A) insolvencies and government corruption
B) decline in asset prices and insolvencies of financial institutions.
C) declining liquidity and low interest rates.
D) high inflation and high interest rates.

Question 56

The mortgage defaults during the 2008-2009 financial crisis severely reduced the capital positions of:

A) major investment banks.
B) government-sponsored enterprises involved in the mortgage market.
C) a large insurance company (AIG).
D) all of the above.

Question 57

Falling house prices generate widespread insolvency of financial institutions by:

A) reducing the value of collateral assets.
B) reducing the value of liabilities.
C) increasing the value of assets.
D) increasing capital.

Question 58

The recession produced by a financial crisis:

A) mitigates the effects of the financial crisis.
B) puts an end to the financial crisis.
C) puts further pressure on asset prices and financial institutions.
D) re-inflates the asset-price bubble.

Question 59

Subprime borrowers are borrowers:

A) who obtain loans at interest rates below the prime rate.
B) most likely to make their loan payments on time.
C) with risky credit profiles.
D) who borrow to purchase smaller homes.

Question 60

The Grameen Bank makes loans primarily to:

A) poor women.
B) first-time home buyers.
C) large corporations.
D) foreign governments.

Question 61

To the extent that failure to appreciate the implications of the decline in house prices on the financial system contributed to the financial crisis of 2008-2009, blame for this mistake lies with:

A) mortgage brokers.
B) investment banks.
C) homebuyers.
D) regulators.

Question 62

Illiquid financial institutions:

A) have assets that are worth less than their liabilities.
B) do not have immediately available funds to make promised payments
C) have negative net worth.
D) do not accept deposits or make loans to households.

Question 63

During the 2008-2009 financial crisis, the Federal Reserve served as a lender of last resort by providing liquidity to:

A) both banks and shadow banks with reliable collateral.
B) any insolvent domestic borrower in the economy.
C) state and local governments.
D) households that were underwater on their mortgages.

Question 64

When the central bank lends to financial institutions in the midst of a liquidity crisis, the central bank is acting as a:

A) lender of last resort.
B) shadow bank.
C) investment bank.
D) mutual fund.

Question 65

To the extent that mortgage defaults contributed to the financial crisis of 2008-2009, blame for these actions lies with:

A) homebuyers who borrowed more than they could afford to repay.
B) mortgage brokers who encouraged households to borrow excessively.
C) government policymakers who pursued policies to encourage homeownership
D) all of the above

Question 66

Conventional monetary and fiscal policies during a financial crisis are aimed at _____, while acting as a lender of last resort or injecting government funds into the financial system during a financial crisis is aimed at _____.

A) increasing output; reducing inflation
B) expanding aggregate demand; fixing the financial system
C) increasing corporate wealth; increasing household wealth
D) expanding aggregate supply; reducing the national debt

Question 67

Ideally, the purpose of providing funds to insolvent banks beyond required insurance payouts is to:

A) transfer funds from taxpayers to financial institutions.
B) give taxpayers ownership in a commercial bank.
C) reward political loyalty.
D) prevent bank failures from multiplying.

Question 68

During the 2008-2009 period, the conventional monetary policy response was to _____ the target federal funds rate, while the conventional fiscal policy response was to _____ taxes and to _____ government spending.

A) increase; increase; increase
B) decrease; decrease; decrease
C) increase; increase; decrease
D) decrease; decrease; increase

Question 69

To the extent that risky mortgage-backed securities that were sold to buyers who were not fully aware of the risks contributed to the financial crisis of 2008-2009, blame for this action lies with:

A) homebuyers.
B) mortgage brokers.
C) investment banks.
D) the Federal Reserve

Question 70

The phrase _____ describes a firm so central to that financial system that policymakers will not allow it to enter bankruptcy.

A) "no bank left behind"
B) "too big to fail"
C) "don't fail, don't bail"
D) "laissez-faire bank"

Question 71

The principal purpose of a central bank acting as a lender of last resort is to:

A) prevent the failure of insolvent financial institutions.
B) maintain the liquidity of the financial system.
C) provide adequate funds to finance the government's spending.
D) keep interest rates as low as possible.

Question 72

When the central bank acts as a lender of last resort, it:

A) requires the borrower to put up collateral.
B) is able to confiscate some of the borrower's assets.
C) requires voting rights on the borrower's board of directors.
D) takes over ownership of the borrower.

Question 73

Conventional fiscal policy was limited during the 2008-2009 financial crisis because of:

A) concerns about increasing the government's budget deficit and debt.
B) difficulties paying out tax rebates.
C) the inability of the government to reduce spending below zero.
D) the inability of the government to raise taxes above 100 percent of income.

Question 74

A situation in which a solvent bank does not have sufficient cash on hand to satisfy the withdrawal demands of depositors is called a(n) _____ crisis.

A) lending
B) shadow
C) insolvency
D) liquidity

Question 75

Conventional monetary and fiscal policies used in a recession are aimed at:

A) increasing aggregate supply.
B) increasing aggregate demand.
C) decreasing aggregate supply.
D) decreasing aggregate demand

Question 76

Conventional monetary policy was limited during the 2008-2009 financial crisis because the central bank could not:

A) purchase enough bonds through open market operations.
B) print a sufficient quantity of money.
C) reduce the target interest rate below zero.
D) adjust the discount rate quickly enough.

Question 77

An illiquid bank can become insolvent when it:

A) refuses to make promised payments.
B) sells additional stock to obtain funds.
C) sells assets at fire-sale prices to meet liquidity demands.
D) can extend the due dates of its liabilities.

Question 78

To the extent that the undervaluation of the riskiness of mortgage-backed securities contributed to the financial crisis of 2008-2009, blame for this mistake lies with:

A) mortgage brokers.
B) investment banks.
C) rating agencies.
D) government policymakers.

Question 79

To the extent that low interest rates contributed to the financial crisis of 2008-2009, the blame for this policy lies with:

A) the Federal Reserve.
B) investment banks.
C) rating agencies.
D) mortgage brokers.

Question 80

A bank with assets worth less than liabilities is said to be _____, while a bank without adequate funds immediately available to make promised payments is said to be _____.

A) inflated; inverted
B) inverted; inflated
C) insolvent; illiquid
D) illiquid; insolvent