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ECO102 Principles of Macroeconomics Problem Session- 2. by Research Assistant Serkan Değirmenci 15 .0 3 .201 2. Today. Mankiw (2008), Principles of Economics: - Chapter 2 7 : The Basic Tools of Finance : ( pages : 597-612) Questions for Review ( QfR ): 1-7 (page: 611 )
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- Chapter 27: TheBasicTools of Finance: (pages: 597-612)
- Chapter 29: The Monetary System:
If the interest rate is 7%,
the present value of $200 to be received in 10 years is $200/(1.07)10 = $101.67.
If the interest rate is 7%,
the present value of $300 to be received 20 years from now is $300/(1.07)20 = $77.53.
Purchasing insurance allows an individual to reduce the level of risk he faces.
Two problems that impede the insurance industry from working correctly are adverse selection and moral hazard. Adverse selection occurs because a high-risk person is more likely to apply for insurance than a low-risk person is.
Moral hazard occurs because people have less incentive to be careful about their risky behavior after they purchase insurance.
Diversification is the reduction of risk achieved by replacing a single risk with a large number of smaller unrelated risks.
A stockholder will get more diversification going from 1 to 10 stocks than from 100 to 120 stocks.(seeFigure 2 on page 604)
“Don’t put allyoureggs in one basket.”
Stocks have more risk because their value depends on the future value of the firm.
Because of its higher risk, shareholders will demand a higher return.
There is a positive relationship between risk and return.
A stock analyst will consider the future profitability of a firm when determining the value of the stock.
The efficient markets hypothesis suggests that stock prices reflect all available information.
This means that we cannot use current information to predict future changes in stock prices.
One piece of evidence that supports this theory is the fact that many index funds outperform mutual funds that are actively managed by a professional portfolio manager.
Economists who are skeptical of the efficient markets hypothesis believe that fluctuations in stock prices are partly psychological.
People may in fact be willing to purchase a stock that is overvalued if they believe that someone will be willing to pay even more in the future.
This means that the stock price may not be a rational valuation of the firm.
The value of the stock is equal to the present value of its dividends and its final sale price.
This is equal to $5/1.08 + $5/(1.08)2 + ($5 + $120)/(1.08)3 = $4.63 + $4.29 + $99.23 = $108.15.
Since this is lower than the initial selling price of $110, XYZ stock is not a good investment.
The future value of $24 invested for 400 years at an interest rate of 7% is
(1.07)400 $24 = $13,600,000,000,000 = $13.6 trillion.
a. The present value of $15 million to be received in four years at an interest rate of 11% is $15 million/(1.11)4 = $9.88 million.Because the present value of the payoff is less than the cost, the project should not be undertaken.
The present value of $15 million to be received in four years at an interest rate of 10% is $15 million/(1.10)4 = $10.25 million. Because the present value of the payoff is greater than the cost, the project should be undertaken.
The present value of $15 million to be received in four years at an interest rate of 9% is $15 million/(1.09)4 = $10.63 million. Because the present value of the payoff is greater than the cost, the project should be undertaken.
The present value of $15 million to be received in four years at an interest rate of 8% is $15 million/(1.08)4 = $11.03 million. Because the present value of the payoff is greater than the cost, the project should be undertaken.
b. The exact cutoff for the interest rate between profitability and nonprofitability is the interest rate that will equate the present value of receiving $15 million in four years with the current cost of the project ($10 million):
Therefore, an interest rate of 10.67% would be the cutoff between profitability and nonprofitability.
a. A sick person is more likely to apply for health insurance than a well person is. This is adverse selection. Once a person has health insurance, he may be less likely to take good care of himself. This is moral hazard.
b. A risky driver is more likely than a safe driver to apply for car insurance. This is adverse selection. Once a driver has insurance, he may drive more recklessly. This is moral hazard.
a. The insurance would increase the amount that individuals spend on clothing. The amount of clothing purchased would likely be greater than the efficient level, because those making the purchase decisions are not paying the entire cost.
b. Individuals who desire or need to spend a lot on clothing will be those most likely to buy clothing insurance.
c. Clothing insurance will cost more than $2,000. Only those who spend more than average will want to purchase the insurance. The insurance company will have to set the premium such that it covers expected losses and administrative costs. Due to the adverse selection problem, the insurance company will end up providing insurance for those who will spend more than $2,000 per year on clothing. Thus, the premium will have to be greater than $2,000.
d. No, this is not a good idea. It leads to overspending on clothing. This issue is very different from health insurance, because purchases of medical care can often be life-or-death decisions. In addition, increases in health lead to higher productivity so total output in the economy can be affected by improvements in health. Last, there may be positive externalities associated with some health expenditures (such as vaccinations).
To reduce the risk associated with the portfolio, it is better to diversify.
This means that the stocks should be of companies from different industries as well as located in different countries.
A stock that is very sensitive to economic conditions will have more risk associated with it. Thus, we would expect for that stock to pay a higher return.
To get stockholders to be willing to accept the risk, the expected return must be larger than average.
Shareholders will likely demand a higher return due to the stock’s firm-specific risk.Firm-specific risk is risk that affects only that particular stock. All stocks in the economy are subject to market risk.
a. If a roommate is buying stocks in companies that everyone believes will experience big profits in the future, the price-earnings ratio is likely to be high. The price is high because it reflects everyone’s expectations about the firm’s future earnings. The largest disadvantage in buying these stocks is that they are currently overvalued and may not pay off in the future.
b. Firms with low price-earnings ratios will likely have lower future earnings. The reason why these stocks are cheap is that everyone has lower expectations about the future profitability of these firms. The largest disadvantage to buying this stock is that the market may be correct and the firm's stock may provide a low return.
a. Answers will vary, but may include things like information on new products under development or information concerning future government regulations that will affect the profitability of the firm.
b. The fact that those who trade stocks based on inside information earn very high rates of return does not violate the efficient markets hypothesis. The efficient market hypothesis suggests that the price of a stock reflects all available information concerning the future profitability of the firm. Inside information is not readily available to the public and thus is not reflected in the stock’s price.
c. Insider trading is illegal because it gives some buyers or sellers an unfair advantage in the stock market.
Answers will vary.
ANSWER: (PAGE: 643)
Money is different from other assets in the economy because it is the most liquid asset available.
Other assets vary widely in their liquidity.
Commodity money is money with intrinsic value, like gold, which can be used for purposes other than as a medium of exchange.
Fiat money is money without intrinsic value; it has no value other than its use as a medium of exchange.
Our economy today uses fiat money.
*the term instrictic value means that the item would have value even if it were not used as money.
Demand deposits are balances in bank accounts that depositors can access on demand simply by writing a check. They should be included in the supply of money because they can be used as a medium of exchange.
The Federal Open Market Committee (FOMC) is responsible for setting monetary policy in the United States.
The FOMC consists of the 7 members of the Federal Reserve Board of Governors and 5 of the 12 presidents of Federal Reserve Banks.
Members of the Board of Governors are appointed by the president of the United States and confirmed by the U.S. Senate.
The presidents of the Federal Reserve Banks are chosen by each bank’s board of directors.
If the Fed wants to increase the supply of money with open-market operations, it purchases U.S. government bonds from the public on the open market.
The purchase increases the number of dollars in the hands of the public, thus raising the money supply.
Banks do not hold 100% reserves because it is more profitable to use the reserves to make loans, which earn interest, instead of leaving the money as reserves, which earn no interest.
The amount of reserves banks hold is related to the amount of money the banking system creates through the money multiplier. The smaller the fraction of reserves banks hold, the larger the money multiplier, because each dollar of reserves is used to create more money.
The discount rate is the interest rate on loans that the Federal Reserve makes to banks.
If the Fed raises the discount rate, fewer banks will borrow from the Fed, so both banks' reserves and the money supply will be lower.
Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.
An increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply.
The Fed cannot control the money supply perfectly because: (1) the Fed does not control the amount of money that households choose to hold as deposits in banks; and
(2) the Fed does not control the amount that bankers choose to lend. The actions of households and banks affect the money supply in ways the Fed cannot perfectly control or predict.
Which of the following are money in the U.S. economy?
Which are not? Explain your answers by discussingeach of the three functions
a. a U.S. penny
b. a Mexican peso
c. a Picasso painting
d. a plastic credit card
a. A U.S. penny is money in the U.S. economy because it is used as a medium of exchange to buy goods or services, it serves as a unit of account because prices in stores are listed in terms of dollars and cents, and it serves as a store of value for anyone who holds it over time.
b. A Mexican peso is not money in the U.S. economy, because it is not used as a medium of exchange, and prices are not given in terms of pesos, so it is not a unit of account. It could serve as a store of value, though.
c. A Picasso painting is not money, because you cannot exchange it for goods or services, and prices are not given in terms of Picasso paintings. It does, however, serve as a store of value.
d. A plastic credit card is similar to money, but represents deferred payment rather than immediate payment. So credit cards do not fully represent the medium of exchange function of money, nor are they really stores of value, because they represent short-term loans rather than being an asset like currency.
What characteristics of an asset make it useful as amedium of exchange?
Asa store of value?
Your uncle repays a $100 loan from Tenth National Bankby writing a $100 check fromhis TNB checking account.Use T-accounts to show the effect of this transaction onyour uncle and on TNB. Has your uncle’s wealthchanged? Explain.
When your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a check from his TNB checking account, the result is a change in the assets and liabilities of both your uncle and TNB, as shown in these T-accounts:
By paying off the loan, your uncle simply eliminated the outstanding loan using the assets in his checking account. Your uncle's wealth has not changed; he simply has fewer assets and fewer liabilities.
Beleaguered State Bank (BSB) holds $250 million indeposits and maintains a reserve ratio of 10 percent.
a. Show a T-account for BSB.
b. Now suppose that BSB’s largest depositorwithdraws $10 million in cash from her account.If BSB decides to restore its reserve ratio byreducing the amount of loans outstanding,showitsnew T-account.
c. Explain what effect BSB’s action will have onotherbanks.
d. Why might it be difficult for BSB to take the actiondescribed in part (b)? Discuss another way for BSBto return to its original reserve ratio.
a.Here is BSB's T-account:
b.When BSB's largest depositor withdraws $10 million in cash and BSB reduces its loans outstanding to maintain the same reserve ratio, its T-account is now:
c.Because BSB is cutting back on its loans, other banks will findthemselves short of reserves and they may also cut back on their loans as well.
d.BSB may find it difficult to cut back on its loans immediately, because it cannot force people to pay off loans. Instead, it can stop making new loans. But for a time it might find itself with more loans than it wants. It could try to attract additional deposits to get additional reserves, or borrow from another bank or from the Fed.
If you take $100 that you held as currency and put it into the banking system, then the total amount of deposits in the banking system increases by $1,000, because a reserve ratio of 10% means the money multiplier is 1/.10 = 10.
Thus, the money supply increases by $900, because deposits increase by $1,000 but currency declines by $100.
With a required reserve ratio of 10%, the money multiplier could be as high as 1/.10 = 10, if banks hold no excess reserves and people do not keep some additional currency. So the maximum increase in the money supply from a $10 million open-market purchase is $100 million.
The smallest possible increase is $10 million if all of the money is held by banks as excess reserves.
Assume that the reserve requirement is 5 percent. All other thing equal, will the money supply expand more if the Federal Reserve buys $2000 worth of bonds or if someone deposits in a bank $2000 that he had been hiding in his cookie jar? If one creates more, how much more does it create? Support your thinking.
The money supply will expand more if the Fed buys $2,000 worth of bonds.
Both deposits will lead to monetary expansion.
But the Fed’s deposit is new money. The $2,000 from the cookie jar is already part of the money supply.
Suppose that the T-account for First National Bank is asfollows:
a. If the Fed requires banks to hold 5 percent ofdeposits as reserves, how much in excess reservesdoes First National now hold?
b. Assume that all other banks hold only the requiredamount of reserves. If First National decides toreduce its reserves to only the required amount,by how much would the economy’s moneysupplyincrease?
a.If the required reserve ratio is 5%, then ABC Bank's required reserves are $500,000 x .05 = $25,000. Because the bank’s total reserves are $100,000, it has excess reserves of $75,000.
b.With a required reserve ratio of 5%, the money multiplier is 1/.05 = 20. If ABC Bank lends out its excess reserves of $75,000, the money supply will eventually increase by $75,000 x 20 = $1,500,000.
Suppose that the reserve requirement for checkingdeposits is 10 percent and that banks do not hold anyexcessreserves.
a. If the Fed sells $1 million of government bonds,what is the effect on the economy’s reserves andmoneysupply?
b. Now suppose the Fed lowers the reserverequirement to 5 percent, but banks choose to holdanother 5 percent of deposits as excess reserves.Why might banks do so? What is the overall changein the money multiplier and the money supply as aresult of theseactions?
a.With a required reserve ratio of 10% and no excess reserves, the money multiplier is 1/.10 = 10. If the Fed sells $1 million of bonds, reserves will decline by $1 million and the money supply will contract by 10 x $1 million = $10 million.
b.Banks might wish to hold excess reserves if they need to hold the reserves for their day-to-day operations, such as paying other banks for customers' transactions, making change, cashing paychecks, and so on.
If banks increase excess reserves such that there is no overall change in the total reserve ratio, then the money multiplier does not change and there is no effect on the money supply.
Assume that the banking system has total reserves of$100 billion. Assume also that required reserves are 10percent of checking deposits, and that banks hold noexcess reserves and households hold no currency.
a. What is the money multiplier? What is the moneysupply?
b. If the Fed now raises required reserves to 20 percentof deposits, what is the change in reserves and thechange in the money supply?
a.With banks holding only required reserves of 10%, the money multiplier is 1/.10 = 10. Because reserves are $100 billion, the money supply is 10 x $100 billion = $1,000 billion.
b.If the required reserve ratio is raised to 20%, the money multiplier declines to 1/.20 = 5. With reserves of $100 billion, the money supply would decline to $500 billion, a decline of $500 billion. Reserves would be unchanged.
Assume that the reserve requirement is 20%. Also assume that banks do not hold excess reserves and there is no cash held by public. The Federal Reserve decides that it wants to expand the money supply by $40 million dollars.
a. If the Fed is using open-market operations, will it buy or sell bonds?
b. What quantity of bonds does the Fed need to buy or sell to accomplish the goal? Explain your reasoning.
a. To expand the money supply, the Fed should buy bonds.
b. With a reserve requirement of 20%, the money multiplier is 1/0.20 = 5. Therefore to expand the money supply by $40 million, the Fed should buy $40 million/5 = $8 million worth of bonds.
Theeconomy of Elmendyn contains 2,000 $1 bills.
a. If people hold all money as currency, what is thequantity of money?
b. If people hold all money as demand deposits andbanks maintain 100 percent reserves, what is thequantity of money?
c. If people hold equal amounts of currency anddemand deposits and banks maintain 100 percentreserves, what is the quantity of money?
d. If people hold all money as demand deposits andbanks maintain a reserve ratio of 10 percent, what isthequantity of money?
e. If people hold equal amounts of currency anddemand deposits and banks maintain a reserveratio of 10 percent, what is the quantity of money?
a.If people hold all money as currency, the quantity of money is $2,000.
b. If people hold all money as demand deposits at banks with 100% reserves, the quantity of money is $2,000.
c. If people have $1,000 in currency and $1,000 in demand deposits, the quantity of money is $2,000.
d. If banks have a reserve ratio of 10%, the money multiplier is 1/.10 = 10. So if people hold all money as demand deposits, the quantity of money is 10 x $2,000 = $20,000.
e. If people hold equal amounts of currency (C) and demand deposits (D) and the money multiplier for reserves is 10, then two equations must be satisfied:
(1) C = D, so that people have equal amounts of currency and demand deposits; and (2) 10 x ($2,000 – C) = D, so that the money multiplier (10) times the number of dollar bills that are not being held by people ($2,000 – C) equals the amount of demand deposits (D). Using the first equation in the second gives 10 x ($2,000 – D) = D, or $20,000 – 10D = D, or $20,000 = 11 D, so D = $1,818.18. Then C = $1,818.18. The quantity of money is C + D = $3,636.36.