Economics s350k

Summer 2014

Practice Problem Set 1

1. Describe the main function of financial markets. Explain how direct finance and indirect finance differ.

2. 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%?

3. 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.

4. 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.

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

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

7. What are the functions of money, i.e. why does money exist? Relative to a barter economy, what problems are overcome by the use of money?

8. To be useful as a medium of exchange, what properties should money have?

9. Describe the evolution of money from barter to fiat money. How did paper money arise?

10. How is money measured? Why is there more than one definition of the money supply? Are data on the money supply reliable?

11. Explain why the interest rate and the price of bonds are inversely related.

12. How do nominal interest rates, ex-ante real interest rates, and ex-post real interest rates differ? Of the two real rates, which is the most important for understanding economic decisions?