Answers to Textbook Questions and Problems CHAPTER 20 The Financial System: Opportunities and Dangers Questions for Review 1. When a company raises funds by issuing bonds, this is called debt finance. The company borrows funds to buy needed capital and then repays the loan at a later date. When a company raises funds by issuing stock, this is called equity finance. The company acquires the funds it needs to by selling stock, or ownership, in its company. 2. The main advantage of holding a stock mutual fund over an individual stock is that stock mutual funds are less risky. Mutual funds are financial intermediaries that sell shares to savers and then use the funds to buy a diversified pool of assets. When you buy a small share of many different stocks, it is less risky than buying stock in only one company because these many companies in the pool are likely to be performing differently at any given time. 3. Adverse selection exists when the person who is borrowing the funds has information about his or her situation that is unobservable to the person who is lending the funds. Sometimes, those most eager to borrow funds possess characteristics that make them the least desirable party to lend to. Banks can reduce the problem of adverse selection by screening potential borrowers and thereby evaluating the odds that the borrower will be successful in using the funds. Moral hazard is the risk that one party to a transaction will act in a way that harms the other party. In financial markets, it exists when the borrower of the funds uses the funds in ways that do not enhance the profitability of the business. The borrower may misuse the funds and therefore earn lower profits that reduce the value of the company. Banks can reduce the problem of moral hazard by including covenants in the loan contract that effectively restrict the borrower’s behavior. This form of monitoring by the bank helps guarantee that the borrowed funds are used for their intended purpose. 4. The leverage ratio is the ratio of a bank’s assets to its bank capital. A leverage ratio of 20 means that the bank assets are 20 times as great as the bank capital. In this case, every $1 of bank capital allows the bank to borrow $19. The higher its leverage ratio, the less stable the financial institution during a time of bad economic news. For example, suppose a bank’s capital is $10 and its assets are $200. If bad economic news reduces the value of the bank assets by 5 percent, this is equivalent to the $10 of bank capital. Beyond this point, the financial institution has no funds with which to pay off future creditors. 5. During a financial crisis, it becomes difficult for consumers and firms to obtain loans and financing for new investment projects. The reduction in loans will reduce spending and the overall demand for goods and services in the economy, causing a leftward shift of the aggregate demand curve. 6. When a central bank acts as a lender of last resort, it helps to alleviate a liquidity crisis. A liquidity crisis occurs when the financial institution has insufficient funds to satisfy the claims of its creditors. In this case, if the central bank lends funds to the financial institution, the creditors’ claims can be met. These actions help to restore and maintain the public’s confidence in the banking system. 7. The benefit of using public funds to help prop up a financial system in crisis is that it helps to maintain confidence in the financial system. A well-functioning financial system helps to facilitate future economic growth. A problem with using public funds to rescue the financial system is that it is unfair to taxpayers since they are paying for the mistakes of others. In addition, if the government offers a bailout, then this can lead to a moral hazard problem in the future. People may believe they can engage in risky behavior because the government will bail them out in a crisis. Problems and Applications 1. a. This is a problem of moral hazard. Once Rick obtains the loan, he changes his behavior and does not follow through on his commitment to write the book. This problem could be dealt with by having Rick commit to a series of deadlines. b. This is a problem of adverse selection. Justin knows something about himself that the publisher does not know. Justin’s poor score on the writing portion of the SAT may impact his ability to write a book. The problem could be dealt with by having the publisher assess Justin’s writing ability prior to giving him the advance. c. This is a problem of adverse selection. Mai knows something about her family history that the insurance company does not know. The problem could be dealt with by having the insurance company ask Mai for a history of her family’s health. d. This is a problem of moral hazard. Erich changes his behavior after he gets the life insurance policy. The problem could be dealt with by restricting payment under certain conditions. There could, for example, be stipulations that limit the amount paid if Erich dies while engaging in risky behavior. 2. a. Nation A will have a higher level of total factor productivity. Total factor productivity measures the effect of any change that results in the same quantity of inputs (labor and capital) yielding a higher level of output. In channeling funds from savers to borrowers, a well-functioning financial system can, all else the same, cause higher levels of economic growth. Entrepreneurs with ideas about how to improve and enhance the production process will be able to acquire needed funds if there is a well-developed financial system. Their ability to do so will lead to a higher level of total factor productivity. In a country like Nation B, with a less-developed financial system, some good investment projects may not happen because the funds to finance them cannot be raised. b. The Solow growth model assumes there is only one type of capital. In this case, if the two countries have the same rates of saving, depreciation, and technological progress, then they will be converging toward the same steady state, assuming they have the same rates of population growth. The levels of output per worker, capital per worker, and the capital-output ratio will be the same between the two countries. But, if there are different types of capital, then Nation A, with the more developed financial system, will be better able to channel funds to projects that lead to higher total factor productivity. As a result, output per worker and capital per worker will be higher in Nation A. c. Assume the Cobb–Douglas production function is given by Y = AL1–αKα, where Y represents output, L is labor, K is the capital stock, and A is total factor productivity. From Chapter 3, we know that real factor prices are equal to the marginal product of the corresponding factor. Therefore, MPL = (1 – α)AL–αKα = W MPK = αAL1–αKα–1 = R. Nation A, with its well-developed financial system, will have higher total factor productivity and therefore higher levels of the real wage and the real rental price of capital. d. Labor and the owners of capital both benefit from having a well-developed financial system because they earn higher income. 3. If people believe that the government will take steps to rescue firms when a financial crisis strikes, then they have an incentive to engage in relatively more risky behavior. This is the moral hazard problem. If, however, the government does not rescue the equity holders, and as a result they lose all of the assets they put into the firm, then this will solve some of the moral hazard problem. If you are an equity holder and you know the government will not bail you out in the event of a financial crisis, then you have an incentive to make sure the financial firm does not engage in overly risky behavior. A firm’s creditors may also engage in overly risky behavior if they believe the government will bail them out if there is a crisis. Creditors can be overly optimistic in deciding which assets to buy. It could, for example, be argued that some buyers of mortgage-backed securities were overly confident in the return that these assets would provide. It is therefore not only the equity holders, but also the creditors that can engage in overly risky behavior. 4. The economic downturns that occurred in both the United States and Greece had similar causes. In the United States, the decline in housing prices led to a string of foreclosures and the subsequent decline in the value of the assets of many financial firms. As people lost confidence in the mortgage-backed securities, the value of these securities fell even further. The result was more stress to the financial system. In Greece, the government had been issuing sovereign debt, which for some time was perceived as risk free. When it became known that Greek debt had increased to 116 percent of GDP, people lost confidence in holding this debt. As the value of the Greek bonds fell, this pushed some financial institutions toward insolvency. In both countries, the credit rating was reduced as a result of the financial crisis, though the reduction in Greece’s credit rating was much more severe than that of the United States. The financial crisis that occurred in both countries resulted in reduced expenditure and, therefore, reduced output. A difference between the two situations involves which party or parties in each country was responsible for the financial crisis. In Greece, the financial crisis was a result of the government’s actions, whereas in the United States it was the result of the actions of private financial firms. Also, the increase in government debt in Greece was a cause of the financial crisis, whereas in the United States the increase in government debt was a result of efforts to help alleviate the crisis. In addition, the two nations had different policy options available to deal with their respective crises because the United States controls its own monetary policy, while Greece does not because they are part of the European Union. The Federal Reserve in the United States has been able to use monetary policy to help control the severity of the crisis by, for example, buying up many of the financial assets that had been losing value. Greece’s only option has been to appeal to the European Union for help in resolving its financial crisis, through loans and/or debt forgiveness. IN THIS CHAPTER, YOU WILL LEARN: ▪ the functions a healthy financial system performs ▪the common features of financial crises ▪ government policies to alleviate or prevent crises▪ The financial system helps channel funds from savers—households with income they do not need to spend immediately… to investors—firms that need funds to finance investment projects ▪ Financial system: the institutions in the economy that facilitate the flow of funds between savers and investors ▪ The financial system includes ▪ financial markets, like the stock market, through which households directly provide funds for investment ▪ financial intermediaries, like banks or mutual funds, through which households indirectly provide funds for investment ▪ Debt finance: selling bonds to raise funds for investment ▪ A bond represents a loan from the bondholder to the firm. ▪ Equity finance: selling stock to raise funds for investment ▪ A share of stock represents an ownership claim by the shareholder in the firm. ▪ Financial intermediaries accept funds from savers and direct them to investors. ▪ For example, banks accept deposits from households and make loans to firms. ▪ Other examples: mutual funds, pension funds, and insurance companies 2. Sharing Risk ▪ Many people are risk averse: other things equal, they dislike uncertainty. ▪ The financial system allows people to share risks: ▪ Investors can share the risk that their projects will fail with the savers who provide the funds. ▪ Savers may be willing to accept these risks for the prospect of a higher return than they could earn otherwise. 2. Sharing Risk ▪ Many people are risk averse: other things equal, they dislike uncertainty. ▪ The financial system allows people to share risks: ▪ Savers can reduce risk through diversification: providing funds to many different investors with uncorrelated assets. ▪ Diversification can reduce idiosyncratic risks, risks that differ across individual businesses. ▪ Diversification cannot reduce systematic risks, which affect most/all businesses. Asymmetric information: when one party to a transaction has more information about it than the other party ▪ Adverse selection: when people with hidden knowledge about attributes sort themselves in a way that disadvantages people with less information ▪ Example: investors who know their projects are less likely to succeed are more eager to finance the projects with other people’s funds Asymmetric information: when one party to a transaction has more information about it than the other party ▪ Moral hazard: arises from hidden knowledge about actions, occurs when imperfectly monitored agents act in dishonest or inappropriate ways. ▪ Example: entrepreneurs investing other people’s money are not as careful as if they were investing their own funds ▪ The financial system helps mitigate the effects of asymmetric information. ▪ Example: banks ▪ Banks address adverse selection by screening borrowers for adverse hidden attributes that savers might not detect. ▪ Banks address moral hazard by restricting how loan proceeds are spent or by monitoring the borrowers. 4. Fostering Economic Growth ▪ In the Solow model, there is one type of capital; in the real world, there are many. ▪ Firms with lucrative investment projects are willing to pay higher interest rates to attract funds than firms with less desirable projects. ▪ The financial system helps channel funds to projects with the highest expected returns relative to their risk. 4. Fostering Economic Growth ▪ Govt helps facilitate this function by providing quality legal institutions, e.g. ▪ prosecuting fraud to reduce moral hazard ▪ enforcing disclosure requirements to reduce adverse selection 1. Asset-Price Booms and Busts ▪ Financial crises often follow a period of optimism and a speculative asset-price bubble. ▪ Eventually, optimism turns to pessimism and the bubble bursts, causing asset prices to drop. In the 2008–2009 crisis, the crucial asset was housing: house prices soared until 2006, then dropped 30% by 2009. 2. Insolvencies at financial institutions ▪ Falling asset prices cause defaults on bank loans. ▪ Since banks are highly leveraged, defaults greatly reduce their capital, increasing the risk of insolvencies. In 2008–2009, many banks held mortgages and assets backed by mortgages. Falling house prices sharply increased mortgage defaults, pushing many financial institutions toward bankruptcy. 3. Falling confidence ▪ Insolvencies at some banks reduce confidence in others, and individuals with uninsured deposits withdraw their funds. ▪ To replace their shrinking reserves, banks must sell assets. Selling by many banks causes steep price declines—called a fire sale. In 2008–2009, the collapse of Bear Stearns and Lehman Brothers reduced confidence in other large institutions, many of which were interdependent. FYI: The TED spread ▪ The TED spread measures the perceived credit risk of banks. ▪ Definition: TED spread = rate on three-month interbank loans – rate on three-month T-bills (expressed in basis points) ▪ The TED spread is usually between 10 and 50 basis points. ▪ In a financial crisis, falling confidence in banks causes the TED spread to rise… 4. Credit crunch ▪Frequent defaults and insolvencies make it hard for investors to get loans—even those with good credit and lucrative projects. In 2008–2009, banks sharply reduced lending to consumers for buying homes and to businesses for expanding operations or buying inventories. 5. Recession ▪ With less credit available, consumer and business spending declines, reducing aggregate demand. ▪ Result: output falls, unemployment rises. In 2008–2009, unemployment rose above 10% and remained very high for many months after the financial crisis. 6. A vicious circle ▪ The recession reduces profits, asset values, and household incomes, which increases defaults, bankruptcies, and stress on financial institutions. ▪ The financial system’s problems and the economy’s downturn reinforce each other. In 2008–2009, the vicious circle was apparent, creating fears the economy would spiral out of control. The Anatomy of a Financial Crisis Who should be blamed for the financial crisis of 2008–2009? Possible culprits include: ▪ The Federal Reserve ▪ Home buyers ▪ Mortgage brokers ▪Investment banks ▪ Rating agencies ▪ Regulators ▪ Government policymakers All of them likely deserve a share of the blame. 1. Conventional monetary policy ▪The central bank can expand the money supply to lower interest rates and encourage spending. The Fed reduced the federal funds rate to nearly zero by 12/2008, yet this was insufficient. (Recall the liquidity trap from Chap.12.) 2. Conventional fiscal policy ▪The government can increase spending and cut taxes. Fiscal policymakers enacted stimulus of $168 billion in 2008 and $787 billion in 2009. But the large and growing government debt sharply limited further stimulus measures. 3. Lender of last resort ▪ Runs on banks can create a liquidity crisis, in which solvent banks have insufficient funds to satisfy depositors’ withdrawals. ▪ The central bank can make direct loans to these banks, acting as a lender of last resort. In 2008–2009, the Fed acted as lender of last resort to many banks and to shadow banks, which perform many of the same functions as banks and were experiencing similar problems. 4. Injections of govt funds ▪ The govt can use public funds to prop up the financial system: ▪ Give funds to those who have experienced losses (e.g., Federal Deposit Insurance) ▪ Make risky loans (e.g., loans to AIG in 2008) ▪ Inject capital into ailing institutions, taking an ownership stake (e.g., TARP) ▪ Using public funds to prop up ailing institutions is controversial and may increase moral hazard. 1. Focusing on shadow banks ▪ Shadow banks engage in financial intermediation and include investment banks, hedge funds, private equity firms, and insurance companies. ▪ Their deposits are not federally insured, so they are not heavily regulated like traditional banks and can take on much more risk. ▪ Their failures can hurt the broader economy, so many policymakers suggest limiting the risk they can take, increasing capital requirements for them, allowing more govt oversight. 2. Restricting size ▪ Institutions deemed “too big to fail” have a moral hazard problem. ▪ Some proposals would limit the size of financial institutions to reduce the harm their failures would cause to the rest of the financial system. ▪ Proposals include limiting mergers and increasing capital requirements for larger banks. 3. Reducing excessive risk taking ▪ To prevent financial firms from failing, some propose limits on excessive risk taking. ▪ Problem: defining “excessive” ▪ The Dodd-Frank Act of 2010 includes the Volcker rule, which prohibits commercial banks from making certain types of speculative investments. 4. Making regulation work better ▪ The regulatory apparatus overseeing the financial system is highly fragmented. ▪ Dodd-Frank and other measures seek to coordinate the various regulatory agencies and improve the effectiveness of financial industry oversight. 5. Taking a macro view of regulation ▪ Traditionally, financial regulation has been microprudential, aiming to reduce the risk of distress in individual financial institutions. ▪ Today, financial regulation is also macroprudential, aiming to reduce system-wide distress to protect against declines in production and employment. The European sovereign debt crisis ▪ Debt problems in Greece: ▪ Rising govt debt, revelations that Greece may have misreported its finances in earlier years ▪ Greek bonds downgraded, prices fell, interest rates shot up as markets worried that Greece might default ▪ Repercussions throughout Europe: ▪ Many European banks held Greek bonds, whose falling values pushed them toward bankruptcy. ▪ Policymakers worried that banks would fail, causing a credit crunch and economic downturn. The European sovereign debt crisis ▪ Bailing out Greece: ▪ The ECB and healthier countries in Europe made loans to Greece to prevent an immediate default. The loans came with conditions that Greece enact austerity measures to improve its finances. ▪ Taxpayers in countries providing the funds resented the bailouts. Greek citizens resented the austerity measures and rioting ensued. ▪ Other countries with problems: ▪ Many feared a Greek default would lead to a run on bonds from Spain, Portugal, Ireland, and Italy. ▪ A healthy financial system serves several purposes, including: ▪ channeling funds from saving to investment ▪ allocating risk ▪ mitigating problems arising from asymmetric information ▪ fostering economic growth ▪ Financial crises begin with a sharp decline in asset prices, often after a speculative bubble. ▪ The fall in asset prices leads to insolvencies, which reduce confidence in the financial system and spur depositors to withdraw their funds. ▪ As a result, banks reduce lending, causing a credit crunch. Business and consumer spending fall, causing an economic downturn. ▪ In a vicious circle, the downturn puts further pressure on asset prices and financial institutions. ▪ Policymakers can respond to a crisis in several ways: by using conventional monetary and fiscal policy to expand aggregate demand, the central bank can provide liquidity by acting as a lender of last resort and the government can use public funds to prop up the financial system. ▪ Policies that aim to prevent future crises include focusing more on regulating shadow banks, restricting the size of financial firms, limiting excessive risk taking, and reforming the regulatory agencies that oversee the financial system. Solution Manual for Macroeconomics Gregory N. Mankiw 9781464182891, 9781319106058
Download
Close
Close
