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
2) Financial Frictions and Crises:
a) Definition:
Financial frictions are inefficiencies or obstacles in the smooth functioning of financial markets. Examples include transaction costs, information asymmetries, credit rationing, and illiquidity.
b) Key Element in Crises:
- Increased financial frictions restrict the flow of credit throughout the system, amplifying economic downturns. Borrowers face difficulties obtaining loans, while lenders become more cautious and risk-averse. This credit crunch weakens investment, consumption, and overall economic activity.
c) Uncertainty and Adverse Selection/Moral Hazard:
- A major financial institution's failure breeds uncertainty, eroding trust in the financial system. This uncertainty intensifies adverse selection, where borrowers with higher risk seek loans while lower-risk borrowers withdraw, distorting lending decisions. Moral hazard also increases, as borrowers engage in riskier behavior due to reduced lender monitoring capabilities.
3) Fed Bond Sale and Monetary Base:
T-accounts:
Before:
After:
Explanation:
- The Fed selling $2 million of bonds to First National Bank increases the bank's reserves by $2 million.
- However, the Fed's liabilities decrease by $2 million as the First National Bank pays for the bonds with deposits.
- Therefore, the monetary base (sum of reserves and currency in circulation) remains unchanged at $100 million.
4) Deposit Shift and Federal Funds Rate:
Supply and Demand Analysis:
Demand for Reserves:
- Banks demand reserves to meet regulatory requirements and facilitate interbank lending.
Supply of Reserves:
- The Fed supplies reserves through open market operations, like the one above, and discount lending.
Deposit Shift to Currency:
- If individuals shift deposits from banks to holding currency, the supply of available reserves in the banking system decreases.
Federal Funds Rate:
- With a decline in reserves, banks become more competitive to borrow from each other to meet their requirements. This increases the demand for federal funds, pushing the interest rate (federal funds rate) up.
Therefore, a shift from deposits to currency leads to a higher federal funds rate due to decreased reserve supply and increased demand for interbank lending.
Sample Answer
1) Used Car Market and Information Asymmetry:
a) Dealer Knows as Much:
When you believe the dealer knows as much about the car as you, you'll likely pay closer to the upper end of the blue book value range ($24,000). This is because you want to avoid underpaying and losing out on a good deal. Since both you and the dealer are assumed to know the same, paying slightly more ensures you secure the car in a competitive market.