1) You are in the market for a used car. At a used car lot, you know that the blue book value for the cars you are looking at is between $20,000 and $24,000. If you believe that the dealer knows as much about the car as you, how much are you willing to pay? Why? Assume that you care only about the expected value of the car you buy and that the care values are symmetrically distributed.
Now, you believe the dealer knows more about the care than you. How much are you willing to pay? Why?
2) Define financial frictions and explain why an increase in financial frictions a key element in financial crises is. How does a general increase in uncertainty as a result of a failure of a major financial institution lead to an increase in adverse selection and moral hazard problem?
3) If the Fed sells $2 million of bonds to the First National Bank, what happens to reserves and the monetary base? Use T-accounts to explain your answer.
4) If a switch occurs from deposits into currency, what happens to the federal funds rate? Use supply and demand analysis of the market for reserves to explain your answer.
Full Answer Section
(b) Dealer knows more about the car:
If you believe the dealer has superior information, your willingness to pay will likely decrease, potentially significantly. You face adverse selection: the dealer is more likely to sell you a car closer to the bottom of the value range ($20,000) while keeping the better cars for themselves. This raises suspicion about the true value of any offered car, making it risky to pay close to the average. You might offer closer to the lower end of the range, depending on your risk tolerance and bargaining power.
2. Financial Frictions and Crises
a) Defining financial frictions:
Financial frictions are obstacles that prevent the smooth functioning of financial markets. Examples include:
- Information asymmetry: Lack of perfect knowledge between borrowers and lenders, leading to adverse selection and moral hazard.
- Transaction costs: Fees and expenses associated with financial transactions, reducing their efficiency.
- Collateral constraints: Limitations on what can be used as collateral for loans, restricting credit availability.
- Liquidity risk: Difficulty for institutions to quickly sell assets to meet obligations, increasing lending costs.
b) Frictions and financial crises:
An increase in financial frictions is a key element in financial crises because it worsens existing vulnerabilities and amplifies financial shocks:
- Adverse selection: Increased uncertainty and distrust make lenders more cautious, leading them to reject good borrowers while approving riskier ones. This concentrates bad loans, increasing system-wide risk.
- Moral hazard: Borrowers, knowing it's harder for lenders to monitor them, engage in riskier activities, further increasing default risk.
- Contagion effect: Difficulties faced by one institution due to friction-induced problems can quickly spread to others through interconnectedness, fueling a broader crisis.
c) Failure of a major institution:
The failure of a major financial institution can also create a general increase in uncertainty, further exacerbating these problems:
- Loss of confidence: Depositors become wary of other institutions, triggering bank runs and liquidity problems.
- Tightening credit: Lenders become even more cautious, reducing credit availability and dampening economic activity.
- Asset value decline: Uncertainty leads to investors selling assets, driving down prices and potentially triggering margin calls, further destabilizing the system.
3. Fed Bond Sale and Monetary Base
T-account analysis:
Fed:
First National Bank:
Explanation:
When the Fed sells $2 million of bonds to the First National Bank, two things happen:
- The Fed receives $2 million from the bank, increasing its government debt liabilities by the same amount.
- The bank pays for the bonds using its reserves, reducing its reserve assets by $2 million.
- Simultaneously, the bank gains $2 million of deposits from the seller of the bonds.
Therefore, the total reserves in the banking system remain unchanged, though their distribution shifts from the Fed to the bank. However, the monetary base (reserves + currency) increases by $2 million as the Fed created new reserves in the process of selling the bonds.
4. Deposits Shift and Federal Funds Rate
Supply and demand of reserves:
The federal funds rate is determined by the supply and demand for reserves in the interbank market.
Deposit shift to currency:
If individuals shift some of their deposits from banks to holding currency, the supply of reserves in the banking system decreases. This reduces the amount of reserves available for interbank lending.
Supply and demand analysis:
- Decrease in supply: With fewer reserves available, banks become less willing to lend to each other in the interbank market. This puts upward pressure on the federal funds rate as demand remains the same or potentially increases due to banks needing to maintain minimum reserve requirements.
- Increased demand: If the deposit shift is a response to financial concerns or economic uncertainty, banks might also become more cautious and increase their own reserve holdings. This further reduces the available pool of reserves and puts even more
Sample Answer
a) Dealer knows as much as you:
Given you believe the dealer knows the true value of the car ($20,000 - $24,000) as much as you, and assuming a symmetrically distributed value, your willingness to pay should be the average of the blue book range - $22,000. This maximizes your expected utility, since any offer above or below represents potential loss on average.