For each of the following pairs which bond would you expect to pay a higher interest rate

Economics 202 Assignment 3: Due October 27th

Assignment 3: Economics 202

Problems for Chapter 13

1. Economists in Funlandia, a closed economy, have collected the following information about the economy for a particular year:

Economists also estimate that the investment function is:

where r is the country’s real interest rate, expressed as a percentage. Calculate private saving, public saving, national saving, investment, and the equilibrium interest rate. Please note: national savings is not related to the interest rate, which means that the supply curve for loanable funds is vertical.

2. In the summer of 2010, Congress passed a far-reaching financial reform to prevent another financial crisis like the one experienced in 2008-2009. Consider the following possibilities:

a. Suppose that, by requiring firms to comply with strict regulations, the bill increases the costs of investment. On a well-labeled graph, show the consequences of the bill on the market for loanable funds. Be sure to specify changes in the equilibrium interest rate and the level of saving and investment. What are the effects of the bill on long-run economic growth (recall: higher investment would increase capital and capital per worker)?

b. Suppose, on the other hand, that by effectively regulating the financial system, the bill increases savers’ confidence in the financial system. Show the consequences of the policy in this situation on a new graph, again noting changes in the equilibrium interest rate and the level of saving and investment. Again evaluate the effects on long run growth.

Problems for Chapter 14

3. According to an old myth, Native Americans sold the island of Manhattan 400 years ago for $24. If they had access to a financial investment that yielded an interest rate of 7% per year, how much would they have today?

4. For each of the following kinds of insurance, give an example of a behavior that can be called moral hazard and another example of behavior that can be called adverse selection:

a. Medical insurance

b. Car insurance

5. For each of the following pairs of bonds, which bond would you expect to pay a higher interest rate? Explain.

a. A bond of the US government or a bond of an Eastern European government

b. A bond that repays the principal in 2015 or a bond that repays the principal in 2040

c. A bond from Coca-Cola or a bond from a software company that run in your garage

d. A bond issued by the federal government or a bond issued by the state of New York

6. 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 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?

7. Jamal has a utility function , where W is his wealth in millions of dollars and U is the utility that he obtains.

a. Is he risk averse? Explain.

b. In the final stage of a game show, the host offers Jamal a choice between:

i. $4 million for sure

ii. A gamble that pays $1 million with 60% probability and $9 million with 40% probability

Should Jamal pick choice i or choice ii? Hint: evaluate the utility that Jamal would expect to receive in choice i and choice ii. Jamal would expect to receive utility in the amount of the weighted average of the possible outcomes, where the probabilities are the weights.

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