Question 1

In which two markets did an asset bubble form that led to a financial crisis in 2008?

Accepted Answer

The housing market and the market for mortgage-backed securities both experienced an asset bubble in the early 2000s, which eventually led to the financial crisis of 2008. The housing market saw rapid price appreciation and relaxed lending standards, while the market for mortgage-backed securities saw a boom in the issuance of risky, subprime mortgages. When borrowers began defaulting on their mortgages, the value of these securities plummeted, leading to widespread losses among investors and triggering a larger financial crisis. The other options listed are not relevant to the 2008 financial crisis.

Question 2

Leverage is best defined as:

Accepted Answer

Leverage refers to using borrowed money to increase potential returns on an investment. This is typically done by purchasing an asset with borrowed funds, such as taking out a mortgage to buy a rental property. Option B refers to nepotism or networking, option C is inaccurate as lenders typically require proof of income before granting a mortgage, and option D refers to an adjustable-rate loan rather than leverage.

Question 3

The two main causes of an asset price bubble are:

Accepted Answer

Herding refers to the phenomenon of individuals following the actions of the crowd without questioning the value or rationale behind those actions. In the context of asset price bubbles, herding can cause prices to be driven up beyond their fundamental value, as more and more investors rush to join in on the buying frenzy. Leverage refers to the use of borrowed funds to finance investments, which can amplify both gains and losses. In the context of asset price bubbles, leverage can exacerbate the effects of herding, as investors borrow money to buy assets that they believe will increase in value, and then use those assets as collateral to borrow even more money to invest. The combination of herding and leverage can create a feedback loop that drives prices up to unsustainable levels, leading to a market crash when the bubble inevitably bursts.

Question 4

Which type of expectations can lead to an asset price bubble?

Accepted Answer

Extrapolative expectations can lead to an asset price bubble because they involve investors expecting future prices to follow past trends, leading to over-optimism and inflated asset prices.

Question 5

I invest $100 in stock, and borrow 90 percent of the $100 at 10 percent.The stock price rises by 20 percent.The rate of return on my investment is:

Accepted Answer

The rate of return on the investment is 110 percent. The investor borrowed 90 percent of the $100 at 10 percent, so the interest on the loan is $9. The stock price rises by 20 percent, so the value of the stock is now $120. The investor's profit is $20, so the rate of return is $20/$100 = 110 percent.

Question 6

Which of the following was not a direct contributor to the booming housing market in the 2000s?

Accepted Answer

Contractionary policy, which involves decreasing government spending and increasing taxes, is not a direct contributor to the housing market boom. The other options-expectations of rising prices, lenient lending standards, and easy access to no-money-down mortgages- all played a role in the housing market's growth during the 2000s.

Question 7

When there is unsustainable rapidly rising prices of some type of financial asset, such as stocks, we refer to this as a(n):

Accepted Answer

An asset price bubble occurs when the prices of assets rise rapidly to levels that are not supported by fundamentals, often leading to a sudden collapse.

Question 8

Suppose you work in investments for a financial institution, and other banks are making a fortune with Irish goldmines.The fact that you are more likely to move to invest in Irish goldmines just because you see other banks doing so is called:

Accepted Answer

The behavior described is herding, which occurs when investors follow the actions of others rather than making independent decisions based on their own analysis. This can lead to market bubbles and crashes, as seen in the 2008 financial crisis. The other options (law of diminishing control, leverage, and diversification) do not accurately describe the behavior being discussed.

Question 9

Potential homebuyers expected house prices to continue to rise, which causes others to believe that they will rise even faster.This is an example of:

Accepted Answer

Extrapolative expectations occur when people expect future trends to follow past trends, such as expecting house prices to continue rising because they have been rising.

Question 10

If housing prices are rising by 20 percent per year, you can borrow money at 5 percent per year, and you are sure housing prices will continue to rise in the future, you would be wise to:

Accepted Answer

Buying as many houses as you can is wise in this scenario because the appreciation rate of the houses (20 percent per year) significantly exceeds the borrowing cost (5 percent per year). This means the value of the houses you buy will increase much faster than the cost of the debt, leading to potential profit.

Question 11

When the Fed loaned to banks using banks' long-run assets such as mortgages as collateral, it was:

Accepted Answer

By loaning money to banks using their long-run assets such as mortgages as collateral, the Fed was providing liquidity to these banks. This is a standard monetary policy tool used to promote economic growth and stability. It does not necessarily indicate a loosening of regulations on banks or a transfer of assets to them.

Question 12

Asset price bubbles are not sustainable because:

Accepted Answer

Asset price bubbles do not reflect an actual increase in the productive value of an asset, which means that the higher prices are not sustainable in the long run. Eventually, investors will realize this and the bubble will burst. This is why asset price bubbles are considered to be a form of speculative excess. Option A is not necessarily true as some people may continue to believe that leverage works even when it does not. Option B may happen, but not all asset price bubbles are burst by government intervention. Option C is only applicable in certain cases where the asset being purchased is finite, such as with real estate, but does not apply to all types of assets.

Question 13

Suppose the people in my town hear a rumor that their local bank is in trouble and all rush to withdraw money from the bank.This is referred to as:

Accepted Answer

A bank run is when a large number of depositors withdraw their money from a bank, usually because of rumors or concerns about the bank's stability. This can lead to a liquidity crisis for the bank and potentially even its failure. Therefore, D is the correct answer. Leverage refers to the use of borrowed funds to increase investment returns, a moral hazard problem arises when one party takes risks knowing that another party will bear the cost of those risks, and a bad precedent problem is when a decision or action sets a negative example for future decisions or actions. None of these concepts accurately describe the scenario presented in the question.

Question 14

Which of the following was not a contributing factor to the housing market boom of the 2000s?

Accepted Answer

The merging of large banks may have contributed to the growth of the financial sector, but it did not directly contribute to the housing market boom of the 2000s. The other options listed all played a significant role in the housing market boom, with low interest rates and mortgages with no or little money down making it easier for people to buy homes, while a lack of concern for their ability to make mortgage payments led to increased risk-taking by lenders.

Question 15

Solvency is having:

Accepted Answer

Solvency refers to the ability of a company to meet its long-term financial obligations. Therefore, having sufficient assets to cover long-run liabilities is the best choice. Option A refers to liquidity, which is the ability of a company to meet its short-term financial obligations. Option B is not desirable as it means an excessive amount of debt that a company may struggle to repay. Option D is not feasible as liabilities cannot cover assets in the long run.

Question 16

The 2008 financial crisis was caused largely by:

Accepted Answer

The 2008 financial crisis was largely caused by the bursting of the housing market bubble. This led to a widespread mortgage default and subsequent collapse of the financial institutions that held them.

Question 17

Why could leverage lead to an asset price bubble?

Accepted Answer

Leverage increases the ability of individuals and institutions to purchase more financial instruments than they could with their own capital alone, potentially inflating asset prices beyond their intrinsic value and contributing to the formation of a bubble.

Question 18

Mortgage -backed securities are financial instruments:

Accepted Answer

Mortgage-backed securities are financial instruments whose value is derived from the underlying mortgages. The investors in these securities receive payments based on the cash flows generated by the mortgages such as the principal and interest payments made by the borrowers. The value of the securities depends on the value of the underlying mortgages and the expected cash flows. While not without risk, mortgage-backed securities are generally considered to be less risky than some other types of securities due to the lower risk of default on mortgages compared to other types of debt.

Question 19

If a financial asset is liquid, it is:

Accepted Answer

A financial asset that is liquid can easily be converted into cash, which makes it a desirable asset to hold. This is important for individuals and businesses who may need quick access to funds in case of an emergency or for investment opportunities. A liquid asset does not necessarily signify safety or lack of risk.

Question 20

Extrapolative expectations are expectations that:

Accepted Answer

Extrapolative expectations are expectations that a trend will continue into the future, based solely on past trends and without considering any other factors.

Quiz 30: Financial Crises, Panics, and Unconventional Monetary Policy