Penn State University Econ 351 Problem Set 3, Summer 2017

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


David views working hard as a personal cost valued at $30. You cannot see how hard David
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?

For Practice
You dont need to submit your answers to this part. However, you will get questions similar
to these questions in the exam.
MULTIPLE CHOICE. Choose the one alternative that best completes the statement or
answers the question.
1) The First Bank of the United States
1) _______
A) was fundamental in helping the Federal Government finance the War of 1812.
B) was disbanded in 1811 when its charter was not renewed.
C) had its charter renewal vetoed in 1832.
D) None of the above.
2) The public's fear of centralized power and distrust of moneyed interests led to the demise of
the first two experiments in central banking, otherwise known as 2) _______
A) the First Central Bank of the United States and the Second Central Bank of the United States.
B) the First Bank of the United States and the Central Bank of the United States.
C) the First Bank of the United States and the Second Bank of the United States.
D) the First Bank of North America and the Second Bank of North America.
3) The Second Bank of the United States
3) _______
A) had its charter renewal vetoed in 1832.
B) is considered to be the primary cause of the bank panic of 1907.
C) was disbanded in 1811 when its charter was not renewed.
D) None of the above.
4) What makes the Federal Reserve so unique compared to other central banks around the world
is its 4) _______
A) decentralized structure.
C) centralized structure.

B) monetary policy functions.
D) regulatory functions.

5) Which of the followings is not a current duty of the Board of Governors of the Federal
Reserve System?
5) _______
A) Setting the maximum interest rates payable on certain types of time deposits under Regulation
B) Setting margin requirements, the fraction of the purchase price of the securities that has to be
paid for with cash.
C) Representing the United States in negotiations with foreign governments on economic
D) Approving the discount rate "established" by the Federal Reserve banks.
6) The Federal Reserve Bank of ________ plays a special role in the Federal Reserve System
because it houses the open market desk.
6) _______
A) Boston

B) San Francisco

C) Chicago

D) New York

7) Each Fed bank president attends FOMC meetings; although only ________ Fed bank
presidents vote on policy, all ________ provide input.
7) _______
A) three; ten B) three; twelve

C) five; twelveD) five; ten

8) Goal independence is the ability of ________ to set monetary policy ________. 8) _______
A) Congress; instruments
B) the central bank; goals
C) the central bank; instruments
D) Congress; goals
9) The ability of a central bank to set monetary policy goals is
A) political independence. B) instrument independence.
C) goal independence. D) policy independence.

9) _______

10) Members of Congress are able to influence monetary policy, albeit indirectly, through their
ability to
10) ______
A) instruct the General Accounting Office to audit the foreign exchange market functions of the
Federal Reserve.
B) propose legislation that would force the Fed to submit budget requests to Congress, as must
other government agencies.
C) withhold appropriations from the Federal Open Market Committee.
D) withhold appropriations from the Board of Governors.

11) Critics of the current system of Fed independence contend that 11) ______
A) the president has too much control over monetary policy on a day-to-day basis.
B) the Board of Governors is held responsible for policy missteps.
C) the current system is undemocratic.
D) voters have too much say about monetary policy.
12) The strongest argument for an independent Federal Reserve rests on the view that subjecting
the Fed to more political pressures would impart
12) ______
A) an inflationary bias to monetary policy. B) a disinflationary bias to monetary policy.
C) a deflationary bias to monetary policy. D) a countercyclical bias to monetary policy.
13) The case for Federal Reserve independence does not include the idea that
13) ______
A) a politically insulated Fed would be more concerned with long-run objectives and thus be a
defender of a sound dollar and a stable price level.
B) a Federal Reserve under the control of Congress or the president might make the so-called
political business cycle more pronounced.
C) political pressure would impart an inflationary bias to monetary policy.
D) policy is always performed better by an elite group such as the Fed.
14) When the value of loans begins to drop, the net worth of financial institutions falls causing
them to cut back on lending in a process called
14) ______
A) deflation. B) releveraging.

C) capitulation.

D) deleveraging.

15) A possible sequence for the three stages of a financial crisis in an advanced economy might
be ________ leads to ________ leads to ________. 15) ______
A) banking crises; increase in uncertainty; increase in interest rates
B) banking crises; increase in interest rates; unanticipated decline in price level
C) asset price declines; banking crises; unanticipated decline in price level
D) unanticipated decline in price level; banking crises; increase in interest rates
16) A financial crisis occurs when an increase in asymmetric information from a disruption in
the financial system 16) ______
A) increases economic activity.
B) allows for a more efficient use of funds.
C) causes severe adverse selection and moral hazard problems that make financial markets
incapable of channeling funds efficiently.

D) reduces uncertainty in the economy and increases market efficiency.
17) A major disruption in financial markets characterized by sharp declines in asset prices and
firm failures is called a
17) ______
A) financial crisis.
B) free-rider problem.
C) "lemons" problem. D) fiscal imbalance.
18) A serious consequence of a financial crisis is 18) ______
A) financial globalization.
B) financial engineering.
C) an increase in asset prices. D) a contraction in economic activity.
19) When the value of loans begins to drop, the net worth of financial institutions falls causing
them to cut back on lending in a process called
19) ______
A) releveraging.

B) deleveraging.

C) deflation. D) capitulation.

20) Debt deflation occurs when
20) ______
A) an economic downturn causes the price level to fall and a deterioration in firms' net worth
because of the increased burden of indebtedness.
B) corporations pay back their loans before the scheduled maturity date.
C) rising interest rates worsen adverse selection and moral hazard problems.
D) lenders reduce their lending due to declining stock prices (equity deflation) that lowers the
value of collateral.
21) Credit card debt is 21) ______
A) restricted debt.
B) unsecured debt.
C) unrestricted debt. D) secured debt.
22) Of the following sources of external finance for American nonfinancial businesses, the least
important is 22) ______
A) bonds and commercial paper.
B) loans from banks.
C) stocks.
D) loans from other financial intermediaries.
23) By bundling share purchases of many investors together mutual funds can take advantage of
economies of scale and thereby lower
23) ______

A) adverse selection. B) moral hazard.
C) diversification.
D) transactions costs.
24) Financial intermediaries develop ________ in things such as computer technology which
allows them to lower transactions costs.
24) ______
A) diversification

B) expertise

C) regulations D) equity

25) The analysis of how asymmetric information problems affect economic behavior is called
________ theory.
25) ______
A) agency

B) uneven

C) principal

D) parallel

26) The current structure of financial markets can be best understood as the result of attempts by
financial market participants to
26) ______
A) deal with the great number of small firms in the United States.
B) cartelize the provision of financial services.
C) adapt to continually changing government regulations.
D) reduce transaction costs.
27) A borrower who takes out a loan usually has better information about the potential returns
and risk of the investment projects he plans to undertake than does the lender. This inequality of
information is called 27) ______
A) noncollateralized risk.
B) asymmetric information.
C) adverse selection. D) moral hazard.
28) An example of the ________ problem would be if Brian borrowed money from Sean in order
to purchase a used car and instead took a trip to Atlantic City using those funds. 28) ______
A) moral hazard
B) agency
C) costly state verification D) adverse selection
29) The free-rider problem occurs because 29) ______
A) information can never be sold at any price.
B) it is never profitable to produce information.
C) people who pay for information use it freely.
D) people who do not pay for information use it.

30) Net worth can perform a similar role to 30) ______
A) intermediation.
B) collateral.
C) diversification.
D) economies of scale.
31) That most used cars are sold by intermediaries (i.e., used car dealers) provides evidence that
these intermediaries 31) ______
A) have solved the moral hazard problem by providing valuable information to their customers.
B) are able to prevent potential competitors from free-riding off the information that they
C) have failed to solve adverse selection problems in this market because "lemons" continue to
be traded.
D) have been afforded special government treatment, since used car dealers do not provide
information that is valued by consumers of used cars.
32) The recent Enron and Tyco scandals are an example of 32) ______
A) the "lemons problem."
B) the adverse selection problem.
C) the free-rider problem.
D) the principal-agent problem.
33) The principal-agent problem would not occur if ________ of a firm had complete
information about actions of the ________. 33) ______
A) managers; owners B) owners; customers
C) owners; managers D) managers; customers
34) One reason financial systems in developing and transition countries are underdeveloped is
34) ______
A) the legal system may be poor making it difficult to enforce restrictive covenants.
B) they have weak links to their governments.
C) they make loans only to nonprofit entities.
D) the accounting standards are too stringent for the banks to meet.
35) Although restrictive covenants can potentially reduce moral hazard, a problem with
restrictive covenants is that 35) ______
A) they are inexpensive to monitor and enforce.
B) they reduce the value of the debt contract.
C) borrowers may find loopholes that make the covenants ineffective.
D) too many resources may be devoted to monitoring and enforcing them, as debtholders
duplicate others' monitoring and enforcement efforts.

36) Professional athletes often have contract clauses prohibiting risky activities such as skiing
and motorcycle riding. These clauses are
36) ______
A) illegal.
B) restrictive covenants.
C) risk insurance.
D) limited-liability clauses.
37) Individuals that lend funds to a bank by opening a checking account are called 37) ______
A) depositors. B) debt holders.
C) policyholders.
D) partners.
38) The government agency that oversees the banking system and is responsible for the conduct
of monetary policy in the United States is 38) ______
A) the United States Treasury.
C) the House of Representatives.

B) the U.S. Gold Commission.
D) the Federal Reserve System.

39) Suppose that from a new checkable deposit, First National Bank holds two million dollars in
vault cash, nine million dollars in excess reserves, and faces a required reserve ratio of ten
percent. Given this information, we can say First National Bank has ________ million dollars in
required reserves.
39) ______
A) one B) two C) eight

D) ten

40) Suppose that from a new checkable deposit, First National Bank holds two million dollars in
vault cash, nine million dollars in excess reserves, and faces a required reserve ratio of ten
percent. Given this information, we can say First National Bank has ________ million dollars
on deposit with the Federal Reserve. 40) ______
A) one B) two C) eight

D) ten

41) Subtracting borrowed reserves from the monetary base obtains 41) ______
A) the borrowed monetary base.
B) high-powered money.
C) the nonborrowed monetary base. D) reserves.
42) The effect of an open market purchase on reserves differs depending on how the seller of the
bonds keeps the proceeds. If the proceeds are kept in ________, the open market purchase has no
effect on reserves; if the proceeds are kept as ________, reserves increase by the amount of the
open market purchase.
42) ______
A) currency; deposits B) deposits; currency
C) currency; currency D) deposits; deposits

43) A simple deposit multiplier equal to four implies a required reserve ratio equal to
A) 100 percent.
B) 50 percent. C) 25 percent. D) 0 percent.


44) Everything else held constant, a decrease in holdings of excess reserves will mean
A) an increase in the money supply. B) a decrease in checkable deposits.
C) an increase in discount loans.
D) a decrease in the money supply.


45) The amount of borrowed reserves is ________ related to the discount rate, and is ________
related to the market interest rate.
45) ______
A) negatively; negatively
C) positively; positively

B) negatively; positively
D) positively; negatively

46) In the model of the money supply process, the depositor's role in influencing the money
supply is represented by
46) ______
A) the currency holdings.
B) the currency holdings and borrowed reserve.
C) the currency holdings and excess reserve.
D) the market interest rate.
47) In the model of the money supply process, the Federal Reserve's role in influencing the
money supply is represented by
47) ______
A) only borrowed reserves.
B) the required reserve ratio, nonborrowed reserves, and borrowed reserves.
C) both the required reserve ratio and the market interest rate.
D) only nonborrowed reserves.
48) The total amount of required reserves in the banking system is equal to the ________ the
required reserve ratio and checkable deposits.
48) ______
A) ratio between
B) sum of
C) product of D) difference between

49) If the required reserve ratio is 10 percent, currency in circulation is $400 billion, checkable
deposits are $1000 billion, and excess reserves total $1 billion, then the money supply is
________ billion.
49) ______
A) $10,000

B) $4000

C) $10,400

D) $1400

50) Assume that no banks hold excess reserves, and the public holds no currency. If a bank sells
a $100 security to the Fed, explain what happens to this bank and two additional steps in the
deposit expansion process, assuming a 10% reserve requirement. How much do deposits and
loans increase for the banking system when the process is completed?