Deskins, Money & the Financial System

Recommended Problems – Solutions 1

Mishkin, Chapter 4

1. The dollar would be worth less with a higher discount rate. The higher the discount
rate, the less valuable a future payment.

2. No, not really. You have won $10 million dollars only in a nominal sense. Those
future payments worth less than the same nominal amount paid in the present.

3. The present value of this security is $3,000.

4. The yield to maturity would be less than 10 percent if the security sold for $3,500.

5. Use this formula:

$2,000 = $100/(1+i) + $100/(1+i)2 + … + $100/(1+i)20 + $1,000(1+i)20,
and solve for i.

6. 25 percent.

9. The one-year bond has a higher yield to maturity.

10. Actually this problem is slightly outdated since the WSJ changed the format of its
bond page. The current yield is a good approximation of the yield to maturity for long-
term bonds.

12. You would rather be holding short-term bonds because the decline in their price
following the decline in interest rates will not be as severe.

13. Not necessarily. Long-term bonds carry more interest rate risk than short-term
bonds. That is, their prices fluctuate more widely in response to market interest rate
fluctuations, compared to short-term bonds.

14. The real interest decreased to 1% (10% – 9%) from 3% (5%-2%), so people are more
likely to buy a home.

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Mishkin, Chapter 5

1. a) Less, because your wealth is lower.

b) More, because the expected return is higher.
c) Less, because relative liquidity of stocks is lower.
d) Less, because the relative expected return is lower.
e) More, because relative risk is lower.

2. a) More, because your wealth is higher.

b) More, because the house has become more liquid
c) Less, because the relative expected return is lower.
d) More, because relative risk is lower.
e) Less, because the expected return is lower.

4. a) More, because bonds are more liquid.

b) More, because the relative expected return is higher.
c) Less, because the relative liquidity is lower.
d) Less, because the expected return is lower.
e) More, because bonds are more liquid.

5. There would be a decline in the demand, and therefore price, of Rembrandts because
their relative expected return is lower.

6. The Fed action increases the supply of bonds, lowering their price and increasing their
yield. This outcome is consistent in the liquidity preference framework.

7. In the bond demand/supply framework, demand and supply both increase, resulting in
an ambiguous outcome regarding prices/yields. In the liquidity preference framework,
there is an increase in money demand, resulting in an unambiguous increase in interest
rates.

10. Increased volatility in gold prices will increase the demand for bonds, driving interest
rates down.

11. This change will drive down the relative expected return to bonds, driving down their
demand, and therefore bond prices.

12. A large federal deficit will increase the supply of bonds, driving up interest rates.

13. In the supply and demand for bonds framework, an increase in the riskiness of bonds
drives demand down, increasing interest rates. In the liquidity preference framework,
there will be an increase in money demand, as the relative riskiness of money decreases,
leading to an increase in interest rates.

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16. If the public believes him (which is a questionable proposition, of course), expected
inflation will fall, which will lead to an increase in bond demand and a decrease in bond
supply, resulting in lower interest rates.

19. This increased volatility will lower the demand for bonds, driving up interest rates.

20. This will have two types of effects, a) a liquidity effect and b) income, price-level,
and expected inflation effects. The liquidity effect, which reflects the reduction the
money supply in the economy, will lead to an increase in interest rates. However, the
income, price-level, and expected inflation effect will lead to reductions in interest rates.
If the liquidity effect dominates, interest rates will increase. However, if the liquidity
effect is dominated, and if the income, price-level, and expected inflation effects take
place slowly, interest rates will rise initially then fall over time. Further, if the liquidity
effect is dominated, and if the income, price-level, and expected inflation effects take
place quickly, interest rates will fall initially and remain at a lower level.

Mishkin, Chapter 7

3. $18.26.

5. The Fed can prick stock bubbles by raising interest rates. First, this action may lead
stock investors to demand higher returns on their equity purchases, thus driving down
prices. Second, this action may reduce growth in the economy, thus lowering expected
dividends, and therefore reducing stock prices.

6. False. To be rational, forecasts just have to be the best available. In the context of
significant uncertainly, even rational forecasts can fluctuate widely.

8. No, because he could improve the accuracy of his forecasts by simply predicting that
tomorrow’s interest rate will be identical to today’s rate. His current forecasts are
therefore not optimal, and therefore do not reflect rational expectations.

9. True. If large changes in stock prices could be predicted, the unexploited profit
opportunities would exist.

10. No. Since the money supply data is widely known, last’s week’s sharp increase in
the money supply was probably incorporated into stock prices about a week ago!

11. The stock’s price should rise.

12. No, this information is publicly available and is probably already reflected in stock
prices.

15. False. Most market participants do not have to follow news to render prices
accurate; only a few participants must do so.

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16. False. Indeed, an efficient market is one in which a person with better information
does profit.

17. In this scenario people will lower their expectations for inflation. As a result, bond
prices will rise and interest rates will fall.

Mishkin, Chapter 8

1. Financial intermediaries can process financial transactions at a lower per unit cost
through economies of scale, thus creating an opportunity for them to enhance efficiency
in financial markets.

2. Financial intermediaries have been able to develop computer technologies that enable
them to process financial transactions at a very low cost, and they can therefore provide
liquidity services to customers very cheaply. They are also able to handle the
transactions associated with makings loans to customers at a very low cost through the
expertise they have developed over time.

3. No. If potential lenders perfectly knew the risk level of potential borrowers, the
adverse selection problem would not exist. Similarly, if lenders could perfectly monitor
the activities of borrowers, and recall loans if excessively risky behavior is undertaken,
the moral hazard problem would not exist.

4. Standard accounting principles make profit verification easier. This allows potential
investors to better differentiate good firms from bad ones, which helps overcome the
problem of adverse selection. Further, it makes it more difficult for managers to
overstate profits, helping to alleviate moral hazard concerns. Overall, by reducing
problems associated with asymmetric information, these reporting principles lead to more
efficient capital allocation.

5. The lemons problem is probably less severe for stocks traded on the NYSE because
these are typically larger firms that are better known in the market place.

6. Smaller, less well-known firms are more likely to use bank financing rather than issue
bonds or sell stocks. Since these firms are less well-known to the typical investor, the
lemons problem impedes their access to capital through direct finance.

8. I would be more likely to make a loan to my friend if she had put her entire life
savings into her business because this would reduce moral hazard concerns, i.e., in this
situation she would be less likely to take excessive risk.

10. True. If the borrower turns out to be a bad credit risk, the collateral can be sold to
repay the loan.

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12. This separation leads to the principal-agent problem. Managers (agents) do not have
as strong of an incentive to maximize profits (the principal’s interest), and instead may
use organizational resources in a way that enhances their own utility, irrespective of
profits.

14. Conflicts of interest may arise if higher profits are generated in one line of service if
the provider misuses information, provides false information, or conceals information
when providing another type of service.

Mishkin, Chapter 9

1. First, the reduction in net worth following the bursting of an asset price bubble may
incentivize firms to take on more risk at lenders’ expense. Second, lower net worth
means less collateral, enhancing the adverse-selection problem, therefore making
borrowers less credit-worthy and leading to a contraction in lending, and therefore,
spending. Third, this can lead to a deterioration in financial institutions’ balance sheets,
which causes them to deleverage, further contributing to the decline in lending.

2. An unexpected drop in the price level renders firms’ real debt load heavier, increasing
adverse selection and moral hazard problems facing lenders, increasing the likelihood of
a financial crisis.

4. A decline in real estate values will reduce the net worth of households and firms that
hold real estate assets. This decline in net worth means that these firms will have less to
risk and have stronger incentives to take on risk at lenders’ expense. Also, lower net
worth means there is less collateral, so the adverse selection problem increases.
Therefore, a real estate price decline can make borrowers less credit-worthy and cause a
contraction in lending and spending. Further, a decline in real estate values can worsen
financial institutions’ balance sheets, which causes them to deleverage, further
contributing to the decline in lending.

5. If this happens, financial institutions will have fewer resources to lend, and lending
will decline. This will reduce investment spending and, therefore, economic activity. In
addition, this decrease in bank lending will increase interest rates, which will increases
asymmetric information problems and leads to a further contraction in lending and
spending.

6. Failure of a major financial institution may lead to a substantial increase in

uncertainly, making it harder to screen good from bad credit risks. Therefore, lenders are
less likely to lend, leading to a reduction in lending and spending.

10. Weak regulation and supervision means that firms may take on excessive risk
because market disciple is weakened by the existence of a government safety net. When
the risky loans eventually go sour, this causes a deterioration in financial institutions’
balance sheets, which leads to a decline in lending and spending.

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12. The development of technology to bundle together many mortgage loans cheaply and
package them into securities lead to the creation of mortgage backed securities and
subprime mortgages.

15. The decline in housing prices incentivized many homeowners to walk away from
their mortgage. This rise in defaults left banks holding the loans which were worth
significantly less, leading to a deterioration of their balance sheets and a collapse in
lending.

16. Sudden capital flows from abroad can fuel credit booms and excessive risk taking.
When the credit boom bursts, there is a deterioration of financial institutions’ balance
sheets, which leads to contractions in lending and spending.

17. It is possible that that regulation and supervision are weak because powerful business
interests lobby to keep it that way, so they can take on more risk, especially in the
presence of a government safety net.

Mishkin, Chapter 10

1. Because borrowing from the Fed may damage the firm’s reputation for potential
creditors and the Fed may restrict a bank’s borrowing capacity in the face of frequent
borrowing.

3. First National
Assets Liabilities
Reserves -50 Deposits -50

Second National
Assets Liabilities
Reserves +50 Deposits +50

5. Reserves fall to $25 million. Since required reserves are $45 million, the bank has a
$20 million reserve shortfall. The bank could a) call in $20 million in loans, b) sell $20
million in loans, c) borrow $20 million from the Fed, d) borrow $20 million from another
bank, e) sell $20 million in securities, or some combination of the above.

6. The banks would rather have the balance sheet in this problem, because after the
deposit outflow of $50 million, the bank would still have excess reserves in the amount of
$5 million.

7. This development has made it easier for banks to acquire funds in response to an
excess reserve shortfall, thus reducing the cost of such a shortfall, and therefore reducing
the need to maintain higher excess reserve holdings, with the accompanying opportunity
cost, to guard against such a shortfall.

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8. Of course not. In such a scenario, a bank would not pass on the opportunity to do
business with a sound customer. Instead, the bank would simply borrow from another
bank, borrow from the Fed, or sell some of its assets to be able to make the loan.

9. To raise its ROE by lowering its capital, the bank can pay out dividends or buy back
some of its stock. To raise its ROE by increasing its assets, the bank can acquire new
funds to seek out new business or purchase securities.

10. The bank can issue new stock to increase capital, cut its dividend payments to
increase capital, or decrease its asset holdings to reduce its asset/capital ratio.

12. Compensating balances can act as collateral. They can also help to establish long-
term customer relationships, which make it easier for banks to gain more information
about potential customers, helping them to overcome the adverse selection problem.

13. False. Sometimes it can make sense for a bank to specialize in certain types of
lending. For example, a bank may develop a particular expertise in screening and
monitoring loans to businesses in a particular type of industry, thus helping them to
overcome adverse selection and moral hazard problems.

Mishkin, Chapter 11

1. There could be adverse selection, for example, if there are people who seek large
property insurance policies with the intent of burning their property for financial gain.
Moral hazard could occur because a person with property insurance has less incentive to
take measures to prevent fire, robbery, etc., after insurance has been purchased.

5. The benefit of a too-big-to-fail policy is that it makes bank panics less likely. The cost
is that it increase moral hazard incentives by big banks because they know that depositors
do not have incentives to monitor their risk-taking activities.

6. The S&L crisis did not occur until the 1980s because a) interest rates were low and
stable before then (at least until the 1970s) and b) 1980s legislation and financial
innovation made it easier for financial institutions to take on more risk.

7. This strategy is dangerous because, once a bank is insolvent, it has even stronger
incentives to commit moral hazard and take on excessive risk. It has little to lose if risky
bets go sour, but it has much to gain if the risky bets pay off. This excessive risk taking
makes it likely the deposit insurance organization will suffer large losses.

10. If politicians are restricted in the amount they can spending on political campaigns,
and therefore, receive from donors, they may be less beholden to special interests and,
correspondingly, better able to serve the voters.

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11. The principle agent problem appears in the context of the S&L crisis because
regulators (agents) do not have the same incentive to minimize costs of deposit insurance
as do the taxpayers (principles). As a result, politicians and regulators relaxed capital
standards, removed restrictions on holdings of risky assets, and engaged in regulatory
forbearance, thereby increasing the cost of the S&L bailout.

12. Eliminating deposit insurance would be beneficial in that it would reduce the moral
hazard banks face to take on more risk. However, the downside of eliminating deposit
insurance it that it would increase the likelihood of bank panics.

14. This would help reduce moral hazard. Banks would be less inclined to take on more
risk because doing so would increase their premiums. The problem is the difficulty in
monitoring the risk level that a bank has taken on.

Mishkin, Chapter 12

1. The U.S. has had a long history of opposition to central power in a broad sense, and
this general sentiment appeared in the context of central banking as well.

3. False. Just because the U.S. has a larger number of banks does not mean that its
banking system is more competitive necessarily. Economists have generally found that
that there does not have to be a very large number of firms in an industry to render the
industry highly competitive. The reason for the larger number of banks in the U.S. is
historic regulations against competition, such as limitations on branching.

5. Until recently, structuring as a bank holding company allowed a bank to a) engage in a

wider array of activities and b) to branch more widely, due to regulatory requirements in
place on traditional banks, but not on bank holding companies.

10. No. The Saudi-owned bank is subject to the same regulations as an American-owned
bank, if it is operating within the U.S.

11. Because reserve requirements act as a tax on deposits, MMMFs have been able to
offer higher returns than savings accounts, since they circumvent this requirement. If
reserve requirements were eliminated, MMMFs would lose this advantage, and would
likely decline in importance.

12. Several factors have played a role in diminishing the cost advantages of banks over
the last several decades. For example, the rise of money market mutual funds offered a
strong alternative to banks.

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13. It is true that high inflation in the 1970s significantly harmed banking in the U.S., in
part because of the interest rate ceilings placed on banks. Therefore the banking industry
would probably be stronger if not for that inflation. However, improved information
technology would still have eroded the income advantages that banks once had on the
assets side of the balance sheet, so at least some decline in banking would have occurred
even without the 1970s inflation.

14. The growth of the commercial paper market and the development of junk bonds
meant that corporations had more alternatives in acquiring funds, thus eroding the
advantage of banks. Securitization has also enabled other financial institutions to
originate loans, again reducing the advantages banks once held.