Question 1

Why are savers often unwise in lending to borrowers who are willing to pay very high interest rates?

Accepted Answer

High-interest rates often attract borrowers who are either risky or in dire financial straits. This is a classic case of adverse selection, where the lender is unable to differentiate between risky and safe borrowers. Moreover, borrowers who are paying very high interest rates may be more likely to default, which creates a moral hazard problem. Overall, lending to such borrowers carries a high risk of default and is not a wise decision for savers.

Question 2

Large firms find external funds to be more costly than internal funds because

Accepted Answer

Large firms find external funds to be more costly than internal funds because outside investors require a higher return to compensate them for having to obtain information about the firms. This is because external funds must be raised from financial markets where investors require a higher return to compensate for the additional risks and uncertainty associated with investing in a publicly traded firm. In contrast, internal funds are generated from the firm's own operations and are therefore less costly.

Question 3

In the basic AD-SRAS model, the assumption is made that

Accepted Answer

The basic AD-SRAS model assumes that all sources of finance are perfect substitutes. This means that there is no preference for one form of financing over another, and all sources are equally desirable to firms in terms of the cost and availability of funds. This assumption simplifies the model and allows for a clear understanding of the relationship between aggregate demand and short-run aggregate supply.

Question 4

A favorable shock to productivity may raise investment by

Accepted Answer

A favorable shock to productivity would increase the profitability of firms, leading to an increase in their internal funds. This would allow them to invest more without relying on external financing from banks or financial markets. Therefore A is the best choice. The other options may also have some impact on investment, but they are less directly related to the productivity shock.

Question 5

Why are banks able to offer funds more cheaply to many borrowers than can financial markets?

Accepted Answer

Banks have an advantage over financial markets in offering funds more cheaply to many borrowers because they have the ability to specialize in gathering information on the creditworthiness of borrowers and monitoring their activities. This allows banks to better assess and manage risk, leading to lower borrowing costs for customers. Financial markets, on the other hand, usually have less information about individual borrowers and face higher costs of managing risk, making it more expensive for them to offer funds to a broad range of borrowers.

Question 6

As a result of asymmetric information

Accepted Answer

Asymmetric information refers to a situation where one party has more information than the other. In the case of investment spending, this means that investors may not have complete information about the true investment opportunities available. As a result, they may be more cautious during a recession, leading to a decrease in investment spending even if there are still good investment opportunities available. This can have a negative impact on economic growth.

Question 7

A majority of lending from savers to borrowers takes place through

Accepted Answer

The majority of lending from savers to borrowers takes place through financial intermediaries such as banks, credit unions, and other financial institutions. These intermediaries collect funds from savers and then lend them out to borrowers who require funds for various purposes such as buying homes, cars, and starting businesses. Financial intermediaries are essential in mobilizing savings and channelling them to productive uses in the economy. Stock and bond markets, direct lending by the government, and private transactions among friends and relatives are not the primary methods of lending and borrowing in the economy.

Question 8

Economists have found that the greater is a borrower's net worth compared to the borrower's desired level of capital investment

Accepted Answer

As the borrower's net worth increases compared to their desired capital investment, they become less risky to lenders and are therefore more likely to receive lower interest rates on external financing. This reduces the gap between the cost of external (higher interest rates) and internal financing (lower interest rates from using their own savings), resulting in a smaller difference between the two costs.

Question 9

For large firms economists have found that

Accepted Answer

Economists have found that for large firms, internal funds are a cheaper source of funds than external funds. This is because external funds come with additional costs such as interest payments and fees, while internal funds do not incur these costs. Additionally, large firms may have more resources available internally to fund their projects and investments.

Question 10

What did President George H. W. Bush and his advisers believe was causing the weakness in the U.S. economy in the fall of 1991?

Accepted Answer

President George H. W. Bush and his advisers believed that a credit crunch, a situation where banks reduce lending due to perceived risks, was causing the weakness in the U.S. economy in the fall of 1991.

Question 11

In which of the following years did the Fed move quickly when signs of a credit crunch appeared?

Accepted Answer

The answer of In which of the following years did...

Question 12

When a borrower's net worth is high,

Accepted Answer

When a borrower's net worth is high, information costs related to borrowing are lower because lenders perceive the borrower as less risky. This reduces the constraints on capital spending due to lower perceived risk.

Question 13

In comparing the actions of the Fed in the fall of 1998 with its actions in the fall of 1991, we can say that

Accepted Answer

In the fall of 1998, the Fed moved quickly to cut interest rates in response to signs of a credit crunch caused by the failure of Long-Term Capital Management. However, in the fall of 1991, the Fed did not move as quickly in response to a credit crunch caused by the savings and loan crisis. Therefore, option C is the correct answer as it correctly states that the Fed moved more quickly to cut interest rates in 1998 than in 1991.

Question 14

What did President Bush's advisers believe should be done about the weakness in the U.S. economy in the fall of 1991?

Accepted Answer

The answer of What did President Bush's advisers believe should...

Question 15

If banks become more willing to make loans, the aggregate demand curve will

Accepted Answer

An increase in banks' willingness to make loans will increase the supply of loanable funds, shifting the supply curve to the right. This will lead to a decrease in the equilibrium real interest rate and an increase in investment spending, which will in turn shift the aggregate demand curve to the right.

Question 16

All else being equal, increases in firms' net worth result in

Accepted Answer

Increases in firms' net worth allow them to fund more capital investment spending, as they have more resources available to them. This can lead to increased growth and profitability for the firm. Adverse selection and moral hazard problems are not directly related to net worth increases. The gap between the cost of internal and external financing may or may not change depending on other factors, so it is not a certain result of net worth increases.

Question 17

For breakdowns in lending by financial institutions to affect the volume of funds flowing from savers to borrowers,

Accepted Answer

If alternative sources of funds to borrowers are perfect substitutes for loans from financial institutions, then breakdowns in lending by financial institutions would not affect the volume of funds flowing from savers to borrowers. However, if these alternative sources are imperfect substitutes, then a breakdown in lending by financial institutions could result in a reduction in the overall volume of funds available to borrowers, as there may not be enough alternative sources to fully compensate for the loss of lending from financial institutions. The interest rates charged by financial institutions and their regulatory environment may also play a role, but they are not as critical as the availability of alternative sources of funding.

Question 18

The main reason that markets for finance do not resemble simple auction markets, such as the market for wheat, is that

Accepted Answer

Markets for finance involve the trading of financial instruments that have complex payoffs and risks, which require savers to expend resources to learn about borrowers. Asymmetric information and the need for due diligence make these markets more complicated than simple auction markets, like the market for wheat, where the products being sold are standard and easily quantifiable.

Question 19

One reason that investment spending tends to decline during recessions is that

Accepted Answer

During recessions, firms often see a decrease in their revenues and profits, which reduces the amount of internal funds available for investment. This reduction in internal financing can lead to a decline in investment spending, as companies may not have sufficient resources to fund new projects or may be more cautious about undertaking new investments in an uncertain economic environment.

Question 20

The key reason why loans from financial institutions and other forms of borrowing are not perfect substitutes is that

Accepted Answer

The reason why loans from financial institutions and other forms of borrowing are not perfect substitutes is due to the existence of information problems in financial markets. This means that lenders may not have complete information on the creditworthiness or risk of the borrower, which can affect the terms and interest rates of the loan. This is not necessarily related to legal requirements or tax treatment, but rather a fundamental issue in financial markets.

Quiz 27: Information Problems and Channels for Monetary Policy