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ECO102

Principles of
Macroeconomics
Problem Session-2
by
Research Assistant
Serkan Deirmenci
15.03.2012
Today
Mankiw (2008), Principles of
Economics:
- Chapter 27: The Basic Tools of
Finance: (pages: 597-612)
Questions for Review (QfR): 1-7 (page: 611)
Problem and Applications (P&A): 1-11 (page:
611-612)
- Chapter 29: The Monetary System:
Questions for Review: 1-2-3-4-5-6-7-8-9 (page:
660)
Problems and Applications: 2-3-4-5-6-7-8-9-10-11-
12-13 (page: 660-661)
Chapter 27: QfR-1 (page:

611)
The interest rate is 7 percent. Use the concept of
present value to compare $200 to be received
in 10 years and $300 to be received in 20 years.
ANSWER:
If the interest rate is 7%,
the present value of $200 to be received in
10 years is $200/(1.07)10 = $101.67.
If the interest rate is 7%,
the present value of $300 to be received 20
years from now is $300/(1.07)20 = $77.53.
Chapter 27: QfR-2 (page:

611)
What benefit do people get from the market for
insurance? What two problems impede the
insurance company from working perfectly?
ANSWER:
Purchasing insurance allows an individual to
reduce the level of risk he faces.
Two problems that impede the insurance industry
from working correctly are adverse selection
and moral hazard. Adverse selection occurs
because a high-risk person is more likely to apply
for insurance than a low-risk person is.
Moral hazard occurs because people have less
incentive to be careful about their risky behavior
after they purchase insurance.
Chapter 27: QfR-3 (page:

611)
What is diversification? Does a stockholder get
more diversification going from 1 to 10 stocks or
going from 100 to 120 stocks?
ANSWER:
Diversification is the reduction of risk achieved by
replacing a single risk with a large number of
smaller unrelated risks.
A stockholder will get more diversification going
from 1 to 10 stocks than from 100 to 120 stocks.
(see Figure 2 on page 604)

Dont put all your eggs in one basket.


Chapter 27: QfR-4 (page:

611)
Comparing stocks and government bonds,
which has more risk? Which pays a higher
average return?
ANSWER:
Stocks have more risk because their value
depends on the future value of the firm.
Because of its higher risk, shareholders will
demand a higher return.
There is a positive relationship between risk and
return.
Chapter 27: QfR-5 (page:

611)
What factors should a stock analyst think about in
determining the value of a share of stock?
ANSWER:
A stock analyst will consider the future
profitability of a firm when determining the
value of the stock.
Chapter 27: QfR-6 (page:

611)
Describe the efficient markets hypothesis and
give a piece of evidence consistent with this
hypothesis.
ANSWER:
The efficient markets hypothesis suggests that
stock prices reflect all available
information.
This means that we cannot use current
information to predict future changes in
stock prices.
One piece of evidence that supports this theory is
the fact that many index funds outperform
mutual funds that are actively managed by
a professional portfolio manager.
Chapter 27: QfR-7 (page:

611)
Explain the view of those economists who are
skeptical of the efficient market hypothesis.
ANSWER:
Economists who are skeptical of the efficient
markets hypothesis believe that fluctuations in
stock prices are partly psychological.
People may in fact be willing to purchase a stock
that is overvalued if they believe that someone
will be willing to pay even more in the future.
This means that the stock price may not be a
rational valuation of the firm.
Chapter 27: P&A-1 (page: 611)
Your bank account pays an interest rate of 8
percent. You are considering buying a share of
stock in XYZ Corporation for $110. After 1,2, and
3 years, it will pay a dividend of $5. You expect to
sell the stock after 3 years for $120. Is XYZ a
good investment? Support your answer with
calculations.
ANSWER:
The value of the stock is equal to the present
value of its dividends and its final sale price.
This is equal to $5/1.08 + $5/(1.08)2 + ($5 +
$120)/(1.08)3 = $4.63 + $4.29 + $99.23 =
$108.15.
Since this is lower than the initial selling
price of $110, XYZ stock is not a good
Chapter 27: P&A-2 (page: 611)
According to an old myth, Native
Americans sold the island of
Manhattan about 400 years ago for
$24. If they had invested this amount
at an interest rate of 7 percent per
year, how much would they have
today?
ANSWER:
The future value of $24 invested for
400 years at an interest rate of 7% is
(1.07)400 $24 =
Chapter 27: P&A-3 (page: 612)
A company has an investment project that would cost $10 million today and yield a
payoff of $15 million in 4 years.
a. Should the firm undertake the project if the interest rate is 11 percent? 10 percent?
9 percent? 8 percent?
b. Can you figure out the exact cutoff for the interest rate between the profitability
and nonprofitability?
ANSWER:
a. The present value of $15 million to be received in four years at an interest rate of 11% is $15
million/(1.11)4 = $9.88 million. Because the present value of the payoff is less than the
cost, the project should not be undertaken.
The present value of $15 million to be received in four years at an interest rate of 10% is $15
million/(1.10)4 = $10.25 million. Because the present value of the payoff is greater than
the cost, the project should be undertaken.
The present value of $15 million to be received in four years at an interest rate of 9% is $15 million/
(1.09)4 = $10.63 million. Because the present value of the payoff is greater than the cost,
the project should be undertaken.
The present value of $15 million to be received in four years at an interest rate of 8% is $15 million/
(1.08)4 = $11.03 million. Because the present value of the payoff is greater than the cost,
$10 15 /(1 x )4
the project should be undertaken.
b. The exact cutoff for the interest rate10(1 x )4 profitability
between 15 and nonprofitability is the interest rate
(1 x )4
that will equate the present value of receiving 1.5
$15 million in four years with the current cost of the
project ($10 million): 1 x (1.5)0.25
1 x 1.1067
x 0.1067
Chapter 27: P&A-4 (page: 612)
For each of the following kinds of insurance, give
an example of behavior that can be called moral
hazard and another example of behavior that
can be called adverse selection.
a. health insurance
b. car insurance
ANSWER:
a. A sick person is more likely to apply for
health insurance than a well person is. This
is adverse selection. Once a person has
health insurance, he may be less likely to
take good care of himself. This is moral
hazard.
b. A risky driver is more likely than a safe
driver to apply for car insurance. This is
Chapter 27: P&A-5 (page: 612)
Imagine that the U.S. Congress, recognizing the importance of being well dressed, started
giveing preferential tax treatment to clothing insurance. Under this new type of insurance,
you would pay the insurance company an annual premium, the insurance company would
than pay for 80 percent of your clothing expenses (you pay the remaining 20 percent), and
the tax laws would partly subsidize your insurance premiums.
a. How would the existence of such insurance affect the amount of clothing that people buy?
How would you evaluate this change in behavior from the standpoint of economic efficiency?
b. Who would choose to buy clothing insurance?
c. Suppose that the average person now spends $2000 a year on clothes. Would clothing
insurance cost more or less than $2000? Explain.
d. In your view, is this congressional action a good idea? How would you compare this idea
with the current tax treatment of health insurance?
ANSWER:
a. The insurance would increase the amount that individuals spend on clothing. The amount
of clothing purchased would likely be greater than the efficient level, because those making
the purchase decisions are not paying the entire cost.
b. Individuals who desire or need to spend a lot on clothing will be those most likely to buy
clothing insurance.
c. Clothing insurance will cost more than $2,000. Only those who spend more than average
will want to purchase the insurance. The insurance company will have to set the premium
such that it covers expected losses and administrative costs. Due to the adverse selection
problem, the insurance company will end up providing insurance for those who will spend
more than $2,000 per year on clothing. Thus, the premium will have to be greater than
$2,000.
d. No, this is not a good idea. It leads to overspending on clothing. This issue is very different
from health insurance, because purchases of medical care can often be life-or-death
decisions. In addition, increases in health lead to higher productivity so total output in the
economy can be affected by improvements in health. Last, there may be positive
Chapter 27: P&A-6 (page: 612)
Imagine that you intend to buy a
portfolio of ten stocks with some of
your savings. Should the stocks be of
companies in the same industry?
Should the stocks be of companies
located in the same country? Explain.
ANSWER:
To reduce the risk associated with
the portfolio, it is better to
diversify.
This means that the stocks
Chapter 27: P&A-7 (page: 612)
Which kind of stock would you expect
to pay the higher average return:
stock in an industry that is very sensitive
to economic conditions (such as an
automaker) or stock in an industry that is
relatively insensitive to economic
conditions (such as a water company)?
Why?
ANSWER:
A stock that is very sensitive to
economic conditions will have more
risk associated with it. Thus, we
would expect for that stock to pay a
Chapter 27: P&A-8 (page: 612)
A company faces two kinds of risk. A firm-
specific risk is that a competitor might
enter its market and take some of its
customers. A market risk is that the
economy might enter a recession,
reducing sales. Which of these two
risks would more likely cause the
companys shareholders to demand a
higher return? Why?
ANSWER:
Shareholders will likely demand a
higher return due to the stocks firm-
specific risk. Firm-specific risk is risk that
Chapter 27: P&A-9 (page: 612)
You have two roommates who invest in the stock market.
a. One roommate says that he buys stock only in companies that
everyone believes will experience big increases in profits in the
future. How do you suppose the price-earnings ratio of these
companies compares to the price-earnings ratio of other
companies? What might be the disadvantage of buying stock in
these companies?
b. Another roommate says he only buys stock in companies that
are cheap, which he measures by a low price-earnings ratio. How
do you suppose the earnings prospects of these companies
compare to those of other companies? What might be the
disadvantage of buying stock in these companies?
ANSWER:
a. If a roommate is buying stocks in companies that everyone
believes will experience big profits in the future, the price-earnings
ratio is likely to be high. The price is high because it reflects
everyones expectations about the firms future earnings. The
largest disadvantage in buying these stocks is that they are
currently overvalued and may not pay off in the future.
b. Firms with low price-earnings ratios will likely have lower future
Chapter 27: P&A-10 (page: 612)
When company executives buy and sell stock based on private
information they obtain as part of their jobs, they are engaged in
insider trading.
a. Give an example of inside information that might be useful for
buying and or selling stock.
b. Those who trade stocks based on inside information usually
earn very high rates of return. Does this fact violate the efficient
markets hypothesis?
c. Insider trading is illegal. Why do you suppose that is?
ANSWER:
a. Answers will vary, but may include things like information on
new products under development or information concerning future
government regulations that will affect the profitability of the firm.
b. The fact that those who trade stocks based on inside
information earn very high rates of return does not violate the
efficient markets hypothesis. The efficient market hypothesis
suggests that the price of a stock reflects all available information
concerning the future profitability of the firm. Inside information is
not readily available to the public and thus is not reflected in the
stocks price.
Chapter 27: P&A-11 (page: 612)
Find some information on an index fund
(such as the Vanguard Total Stock Market
Index, ticker symbol VTSMX). How has this
fund performed compared with other stock
mutual funds over the past 5 or 10 years?
(Hint: One place to look for data on mutual
funds is http://www.morningstar.com.)
What do you learn from this comparison?
ANSWER:
Answers will vary.
Chapter 29: QfR-1 (page:
660)
What distinguishes money from other assets in
the economy?
ANSWER: (PAGE: 643)
Money is different from other assets in the
economy because it is the most liquid asset
available.
Other assets vary widely in their liquidity.
Chapter 29: QfR-2 (page:
660)
What is commodity money? What is fiat money?
Which kind do we use?
ANSWER: (PAGE: 643-645)
Commodity money is money with intrinsic
value, like gold, which can be used for purposes
other than as a medium of exchange.
Fiat money is money without intrinsic value; it
has no value other than its use as a medium of
exchange.
Our economy today uses fiat money.

*the term instrictic value means that the item would


have value even if it were not used as money.
Chapter 29: QfR-3 (page:
660)
What are demand deposits, and why should they
be included in the stock of money?
ANSWER: (PAGE: 646)
Demand deposits are balances in bank accounts
that depositors can access on demand simply by
writing a check. They should be included in the
supply of money because they can be used as
a medium of exchange.
Chapter 29: QfR-4 (page:
660)
Who is responsible for setting monetary policy in
the United States? How is this group chosen?
ANSWER: (PAGE: 648-649)
The Federal Open Market Committee
(FOMC) is responsible for setting monetary policy
in the United States.
The FOMC consists of the 7 members of the
Federal Reserve Board of Governors and 5 of the
12 presidents of Federal Reserve Banks.
Members of the Board of Governors are appointed
by the president of the United States and
confirmed by the U.S. Senate.
The presidents of the Federal Reserve Banks are
Chapter 29: QfR-5 (page:
660)
If the Fed wants to increase the money supply
with open-market operations, what does it do?
ANSWER: (PAGE: 653)
If the Fed wants to increase the supply of money
with open-market operations, it purchases U.S.
government bonds from the public on the
open market.
The purchase increases the number of dollars in
the hands of the public, thus raising the money
supply.
Chapter 29: QfR-6 (page:
660)
Why dont banks hold 100 percent reserves? How
is the amount of reserves banks hold related to
the amount of money the banking system
creates?
ANSWER: (PAGE: 650-651-653-653)
Banks do not hold 100% reserves because it is
more profitable to use the reserves to make
loans, which earn interest, instead of leaving the
money as reserves, which earn no interest.
The amount of reserves banks hold is related to
the amount of money the banking system creates
through the money multiplier. The smaller the
fraction of reserves banks hold, the larger the
money multiplier, because each dollar of reserves
Chapter 29: QfR-7 (page:
660)
What is the discount rate? What happens to the
money supply when the Fed raises the discount
rate?
ANSWER: (PAGE: 655-656)
The discount rate is the interest rate on loans
that the Federal Reserve makes to banks.
If the Fed raises the discount rate, fewer
banks will borrow from the Fed, so both banks'
reserves and the money supply will be lower.
Chapter 29: QfR-8 (page:
660)
What are reserve requirements? What happens to
the money supply when the Fed raises reserve
requirements?
ANSWER: (PAGE: 654)
Reserve requirements are regulations on the
minimum amount of reserves that banks must
hold against deposits.
An increase in reserve requirements raises
the reserve ratio, lowers the money
multiplier, and decreases the money supply.
Chapter 29: QfR-9 (page:
660)
Why cant the Fed control the money supply
perfectly?
ANSWER: (PAGE: 656)
The Fed cannot control the money supply
perfectly because: (1) the Fed does not control
the amount of money that households choose to
hold as deposits in banks; and
(2) the Fed does not control the amount that
bankers choose to lend. The actions of
households and banks affect the money supply in
ways the Fed cannot perfectly control or predict.
Chapter 29: P&A-2
(page: 660)
Which of the following are money in the U.S. economy?
Which are not? Explain your answers by discussing each of the three functions
of money.
a. a U.S. penny
b. a Mexican peso
c. a Picasso painting
d. a plastic credit card
ANSWER:
a. A U.S. penny is money in the U.S. economy because it is used as a medium
of exchange to buy goods or services, it serves as a unit of account
because prices in stores are listed in terms of dollars and cents, and it
serves as a store of value for anyone who holds it over time.
b. A Mexican peso is not money in the U.S. economy, because it is not used
as a medium of exchange, and prices are not given in terms of pesos, so it
is not a unit of account. It could serve as a store of value, though.
c. A Picasso painting is not money, because you cannot exchange it for goods
or services, and prices are not given in terms of Picasso paintings. It does,
however, serve as a store of value.
d. A plastic credit card is similar to money, but represents deferred payment
rather than immediate payment. So credit cards do not fully represent
the medium of exchange function of money, nor are they really
stores of value, because they represent short-term loans rather
Chapter 29: P&A-3
(page:
What characteristics 660)
of an asset make it useful as a medium of
exchange?
As a store of value?
ANSWER:
For an asset to be useful as a medium of exchange, it must
be widely accepted (so all transactions can be made in
terms of it), recognized easily as money (so people can
perform transactions easily and quickly), divisible (so
people can provide change), and difficult to counterfeit (so
people will not print their own money). That is why nearly
all countries use paper money with fancy designs for larger
denominations and coins for smaller denominations.

For an asset to be useful as a store of value, it must be


something that maintains its value over time and
something that can be used directly to buy goods and
services or sold when money is needed. In addition to
Chapter 29: P&A-4 (page: 660)
Your uncle repays a $100 loan from Tenth National Bank by writing
a $100 check from his TNB checking account. Use T-accounts to
show the effect of this transaction on your uncle and on TNB. Has
your uncles wealth changed? Explain.
ANSWER:
When your uncle repays a $100 loan from Tenth National Bank
(TNB) by writing a check from his TNB checking account, the result
is a change in the assets and Your liabilities
Uncle of both your uncle and
TNB, as shown in these T-accounts:
Assets Liabilities
Before:
Checking Account $100 Loans $100
After:
Checking Account $0 Loans $0
Tenth National Bank
Assets Liabilities
Before:
Loans $100 Deposits $100
After:
Loans $0 Deposits $0
By paying off the loan, your uncle simply eliminated the
outstanding loan using the assets in his checking account. Your
uncle's wealth has not changed; he simply has fewer assets and
fewer liabilities.
Chapter 29: P&A-5
(page:
Beleaguered State Bank 660)
(BSB) holds $250 million in deposits and
maintains a reserve ratio of 10 percent.
a. Show a T-account for BSB.
b. Now suppose that BSBs largest depositor withdraws $10 million in
cash from her account. If BSB decides to restore its reserve ratio by
reducing the amount of loans outstanding, show its new T-account.
c. Explain what effect BSBs action will have on other banks.
d. Why might it be difficult for BSB to take the action described in part
(b)? Discuss another way for BSB to return to its original reserve ratio.
Chapter 29: P&A-5 (page: 660)-
ANSWER:
cont.
a. Here is BSB's T-account:
Beleaguered State Bank
Assets Liabilities
Reserves $25 million Deposits $250 million
Loans $225 million

b. When BSB's largest depositor withdraws $10 million in cash and


BSB reduces its loans outstanding to maintain the same reserve
ratio, its T-account isBeleaguered
now: State Bank
Assets Liabilities
Reserves $24 million Deposits $240 million
Loans $216 million

c. Because BSB is cutting back on its loans, other banks will find
themselves short of reserves and they may also cut back on their
loans as well.
d. BSB may find it difficult to cut back on its loans immediately,
because it cannot force people to pay off loans. Instead, it can stop
making new loans. But for a time it might find itself with more loans
than it wants. It could try to attract additional deposits to get
Chapter 29: P&A-6
(page:
You take $100 660)
you had kept under your mattress
and deposit it in your bank account. If this $100
stays in the banking system as reserves and if
banks hold reserves equal to 10 percent of
deposits, by how much does the total amount of
deposits in the banking system increase? By how
much does the money supply increase?
ANSWER:
If you take $100 that you held as currency and
put it into the banking system, then the total
amount of deposits in the banking system
increases by $1,000, because a reserve ratio of
10% means the money multiplier is 1/.10 = 10.
Thus, the money supply increases by $900,
because deposits increase by $1,000 but
Chapter 29: P&A-7
The Federal(page: 660)a $10 million
Reserve conducts
open-market purchase of government bonds. If
the required reserve ratio is 10 percent, what is
the largest possible increase in the money
supply that could result? Explain. What is the
smallest possible increase? Explain.
ANSWER:
With a required reserve ratio of 10%, the money
multiplier could be as high as 1/.10 = 10, if
banks hold no excess reserves and people do
not keep some additional currency. So the
maximum increase in the money supply
from a $10 million open-market purchase
is $100 million.
Chapter 29: P&A-8
(page: 660)
Assume that the reserve requirement is 5
percent. All other thing equal, will the money
supply expand more if the Federal Reserve
buys $2000 worth of bonds or if someone
deposits in a bank $2000 that he had been
hiding in his cookie jar? If one creates more,
how much more does it create? Support your
thinking.
ANSWER:
The money supply will expand more if
the Fed buys $2,000 worth of bonds.
Both deposits will lead to monetary
expansion.
Chapter 29: P&A-9
Suppose that the(page:
T-account for First660)
National Bank is as follows:

a. If the Fed requires banks to hold 5 percent of deposits as


reserves, how much in excess reserves does First National now
hold?
b. Assume that all other banks hold only the required amount of
reserves. If First National decides to reduce its reserves to only the
required amount, by how much would the economys money
ANSWER:
supply increase?
a. If the required reserve ratio is 5%, then ABC Bank's required
reserves are $500,000 x .05 = $25,000. Because the banks
total reserves are $100,000, it has excess reserves of $75,000.

b. With a required reserve ratio of 5%, the money multiplier is


1/.05 = 20. If ABC Bank lends out its excess reserves of
$75,000, the money supply will eventually increase by $75,000
x 20 = $1,500,000.
Chapter 29: P&A-10
Suppose that the(page: 661)
reserve requirement for checking deposits is 10
percent and that banks do not hold any excess reserves.
a. If the Fed sells $1 million of government bonds, what is the
effect on the economys reserves and money supply?
b. Now suppose the Fed lowers the reserve requirement to 5
percent, but banks choose to hold another 5 percent of deposits as
excess reserves. Why might banks do so? What is the overall
change in the money multiplier and the money supply as a result
of these actions?
ANSWER:
a. With a required reserve ratio of 10% and no excess reserves,
the money multiplier is 1/.10 = 10. If the Fed sells $1 million of
bonds, reserves will decline by $1 million and the money supply
will contract by 10 x $1 million = $10 million.
b. Banks might wish to hold excess reserves if they need to hold
the reserves for their day-to-day operations, such as paying other
banks for customers' transactions, making change, cashing
paychecks, and so on.
If banks increase excess reserves such that there is no
Chapter 29: P&A-11
(page:
Assume that the banking system661)
has total reserves of $100
billion. Assume also that required reserves are 10 percent
of checking deposits, and that banks hold no excess
reserves and households hold no currency.
a. What is the money multiplier? What is the money supply?
b. If the Fed now raises required reserves to 20 percent of
deposits, what is the change in reserves and the change in
the money supply?
ANSWER:
a. With banks holding only required reserves of 10%, the
money multiplier is 1/.10 = 10. Because reserves are $100
billion, the money supply is 10 x $100 billion = $1,000
billion.

b. If the required reserve ratio is raised to 20%, the money


multiplier declines to 1/.20 = 5. With reserves of $100
billion, the money supply would decline to $500 billion, a
Chapter 29: P&A-12
(page:
Assume that the 661)
reserve requirement is 20%. Also assume
that banks do not hold excess reserves and there is no cash
held by public. The Federal Reserve decides that it wants to
expand the money supply by $40 million dollars.
a. If the Fed is using open-market operations, will it buy or
sell bonds?
b. What quantity of bonds does the Fed need to buy or sell
to accomplish the goal? Explain your reasoning.

ANSWER:
a. To expand the money supply, the Fed should buy bonds.

b. With a reserve requirement of 20%, the money multiplier


is 1/0.20 = 5. Therefore to expand the money supply by
$40 million, the Fed should buy $40 million/5 = $8 million
worth of bonds.
Chapter 29: P&A-13
The economy(page: 661)
of Elmendyn contains 2,000 $1 bills.
a. If people hold all money as currency, what is the
quantity of money?
b. If people hold all money as demand deposits and
banks maintain 100 percent reserves, what is the
quantity of money?
c. If people hold equal amounts of currency and
demand deposits and banks maintain 100 percent
reserves, what is the quantity of money?
d. If people hold all money as demand deposits and
banks maintain a reserve ratio of 10 percent, what is
the quantity of money?
e. If people hold equal amounts of currency and
demand deposits and banks maintain a reserve ratio
of 10 percent, what is the quantity of money?
Chapter 29: P&A-13 (page:
ANSWER:
661)-cont.
a. If people hold all money as currency, the quantity of money is
$2,000.
b. If people hold all money as demand deposits at banks with 100%
reserves, the quantity of money is $2,000.
c. If people have $1,000 in currency and $1,000 in demand deposits,
the quantity of money is $2,000.
d. If banks have a reserve ratio of 10%, the money multiplier is 1/.10
= 10. So if people hold all money as demand deposits, the
quantity of money is 10 x $2,000 = $20,000.
e. If people hold equal amounts of currency (C) and demand deposits
(D) and the money multiplier for reserves is 10, then two
equations must be satisfied:
(1) C = D, so that people have equal amounts of currency and
demand deposits; and (2) 10 x ($2,000 C) = D, so that the
money multiplier (10) times the number of dollar bills that are not
being held by people ($2,000 C) equals the amount of demand
deposits (D). Using the first equation in the second gives 10 x
($2,000 D) = D, or $20,000 10D = D, or $20,000 = 11 D, so D
to be continued