Financial Markets

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1. How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger?

Because you know your family member better than a stranger, you know more about the borrower’s honesty, propensity for risk taking, and other traits. There is less asymmetric information than with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member.

2. If mortgage rates rise from 5% to 10%, but the expected rate of increase in housing prices rises from 2% to 9%, are people more likely or less likely to buy houses? Explain you answer.

People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3 percent (5 percent –2 percent) to 1 percent (10 percent –9 percent). The real cost of financing the house is thus lower, even though mortgage rates have risen. (If the tax deductibility of interest payments is allowed for, then it becomes even more likely that people will buy houses.)

3. Using the supply and demand for bonds framework, explain and show why interest rates are procyclical (rising when the economy is expanding and falling during recessions).

When the economy booms, the demand for bonds increases: the public’s income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves (Bd and Bs) shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises. Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the bond price rises and the interest rate falls. The conclusion is that bond prices fall and interest rates rise during booms and fall during recessions: that is, interest rates are procyclical.

4. The president of the United States announces in a press conference that he will fight the higher inflation rate with a new anti-program. Predict what will happen to interest rates if the public believes him? Explain your answer.

If the public believes the president’s program will be successful, interest rates will fall. The president’s announcement will lower expected inflation so that the expected return on goods decreases relative to bonds. The demand for bonds increases and the demand curve, Bd, shifts to the right. For a given nominal interest rate, the lower expected inflation means that the real interest rate has risen, raising the cost of borrowing so that the supply of bonds falls. The resulting leftward shift of the supply curve, Bs, and the rightward shift of the demand curve, Bd, causes the equilibrium bond price to rise and the interest rate to fall. 5. What effect would reducing income tax rates have on the interest rates of municipal bonds? Would interest rates of Treasury securities be affected and, if so, how. Explain your answers.

The reduction in income tax rates would make the tax-exempt privilege for municipal bonds less valuable, and they would be less desirable than taxable Treasury bonds. The resulting decline in the demand for municipal bonds and increase in demand for Treasury bonds would raise interest rates on municipal bonds while causing interest rates on Treasury bonds to fall.

6. Can a person with optimal expectations expect the price of Google to rise by 10% in the next month? Explain your answer.

No, if the person has no better information than the rest of the market. An expected price rise of 10% over the next month implies over a 100% annual return on IBM stock, which certainly exceeds its equilibrium return. This would mean that there is an unexploited profit opportunity in the market, which would have been eliminated in an efficient market. The only time that the person’s expectations could be rational is if...
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