Penn State Econ 351 Summer 2014 Problem Set 3

Econ 351 (section 201), Penn State University Summer 2014
Problem Set 3
1) (10 points) True or False? Explain.
“Financial engineering always leads to a more efficient financial system.”

2) (25 points) You wish to hire David to manage your shop. The profits from operations depend on how hard David works as follows:
Profit=$100 Profit=$300

Lazy 50% 50%
Hard 20% 80%

David views working hard as a “personal cost” valued at $30. You cannot see how hard David works.
a) What kind of asymmetric information do you suffer from in this example?
b) What fixed percentage of the profit should you offer David to make sure that he works hard. Assume that David cares only about his expected payment less any “personal cost.”

3) (25 points) What specific procedures do financial intermediaries use to reduce asymmetric information problems in lending?
4) (25 points) How can a bursting of an asset-price bubble in the stock market help trigger a financial crisis?
5) (30 points total) Suppose that the currency in circulation is $600 billion, the amount of checkable deposits is $900 billion, and excess reserves are $15 billion.
a) (10 points) Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and the money multiplier.
b) (5 points) Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of $1400 billion due to a sharp contraction in the economy. Assuming the ratios you calculated in part “a” are the same, what do you predict will be the effect on the money supply?
c) (10 points) Suppose that the central bank conducts the same open market purchase as in part b, except that banks chose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis. Assuming that currency and deposits remain the same, what happens to the amount of excess reserves, the excess reserve ratio, the money supply, and the money multiplier?
d) (5 points) Following the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, and at the same time, very little lending occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011. How does this relate to your answer to part c? 

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