Week 5

1. We discussed in class the behavior of interest rates over time in response to an expansion of the money supply, finding that there were three possible interest rate profiles that could be observed following such a monetary expansion. Repeat this analysis for the case of a decrease in the money supply (a monetary contraction).

2. (a) List the four factors in the economic environment that can lead to a substantial deterioration of firms' balance sheets that can worsen adverse selection and moral hazard problems in financial markets, eventually leading to a financial crisis. List the four factors that have triggered most financial crises in the United States.

3. (Mishkin, ch. 8, #4) How do standard accounting principles required by the government help financial markets work more efficiently?

4. (Mishkin, ch. 8, #11) How does the free-rider problem aggravate adverse selection and moral hazard problems in financial markets?

5. Consider a fictional economy in which there is one firm and one household (on a deserted island, say). We are at the end of a year in which the firm had total revenue of $10,000, wage expenses of $7,000 (paid to the household), and $1,000 in other expenses. The firm paid the household $1,000 in dividends at the end of the year. The firm does not have any net worth (equity) carried over from previous years of operation. Over this same time period the household consumed goods and services worth $6,000 and saved the rest of the funds received from the firm. If the loanable funds market is in equilibrium in this economy, how much investment expenditure must the firm be planning to make?