Economics 470/570

Fall 2009

Due: End of class on Thursday, 10/8

1. Suppose that there are 10 individuals, each with $10,000 in savings that they would like to lend, but only if there is little to no chance that they will lose their investment. Suppose there are also 10 different people who want to take out $10,000 loans. (a) Assuming an expected default rate of 10% and an interest rate on loans of 20%, use this example to show how pooling risk through financial intermediation can increase the efficiency of financial markets. (b) Assuming the default rate using financial intermediation is exactly 10%, what is the interest rate at which the return is 0%?

2. Suppose that there are 10 individuals, each with $10,000 in savings that they would like to lend. Suppose there another person who wants to take out a $100,000 loan. Use this example to show how pooling small deposits through financial intermediation can increase the efficiency of financial markets.

3. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. However, in any given year 20% of them will need the money for emergencies. Because of this possibility, and the dire consequences if they cannot access their money at such a time, none of them are unwilling to lend the money for long periods of time. Explain how financial intermediation can solve this problem of "borrowing short and lending long" and increase the efficiency of financial markets.

4. Besides pooling risk, pooling small deposits, and pooling over time, what else do financial intermediaries do to increase the efficiency of financial markets?

5. Briefly, what does the phrase “increase the efficiency of financial markets” mean?

6. You have been put in charge of selecting a new medium of exchange for the economy. Choose something to serve as money, and evaluate it in terms of the properties that a medium of exchange must satisfy in order to be useful.