1: Can you think of a reason why people in general do not lend money to one another to buy a

house or a car ? How would your answer explain the existence of banks ?

There are several reasons to it. One of the important reason is people do not know how safe it is
to lend to the other person as they do not have information or capability to determine someone’s
credit worthiness. Banks use mathematical methods along with information processing to profile
the borrower and lend him/her accrodingly with an appropriate interest rate and
conditons.Moreover, Banks can take risk of loan going bad as they have access to pool of funds
and diversification of lending leads to hedging of lending risk.

2. Some economists suspect that one of the reasons economies in developing countries grow so
slowly is that they do not have well-developed financial markets. Does this argument make sense
?

Gowth of economy in GDP terms has an important factor of investment. More the investment
into businesses better does the economy grows. When the financial markets are under developed
it means there are lesser number of participants who are willing to invest, it can also mean the
right business might not get the right amount at the right time due to information assymetry in
the market or weak channeling mechanism for funds. All this thus hamper the growth of
businesses and ultimately the growth of country. One more factor that is related to it is the rise of
cost of fund for businesses due to under developed financial markets. It adversly affects
profitability and growth.

3. Financial regulation is similar, but not exactly the same, in industrialized countries. Discuss
why it might be desirable—or undesirable—to have the same financial regulation across
industrialized countries.

There are two side of this topic. One is that there is huge diversity in our world. The way Asian
world works is different than how US works. There is difference in culture about money (like
Islamic banking does not prefer lending money) then there are different economic models like a
capitalist , socialist and mixed type. Designing a one size fit all financial regualtion is thus more
likely to compromise on stability of entire system by undermining at least on of the local
economies. However, there is argument that with globalistion of international trade financial
transaction are more or less uniform type and hence in order to preserve stability of currency and
fund flows common minimum financial regualtions must be designed.

4: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 or less likely to buy houses ?

For this we rely on metric of real interest rate instead of nominal rate as the real interest rate is
what finally the buyer will have to pay out. Here real interest rate is going from 3% to 1% ( 10-
9%). This means that financing the homes is now actually cheaper for consumer due to rise in
housing prices in simultaneous with rise in mortgage prices.

5: An important way in which the Federal Reserve decreases the money supply is by selling
bonds to the public. Using a supply and demand analysis for bonds, show what effect this action
has on interest rates. Is your answer consistent with what you would expect to find with the
liquidity preference framework ?

Selling the bonds to the public increases the supply of bond in the market, this means that the
supply curve shifts to the right. Rest all remaining same, it means now the supply curve cuts the
demand curve on a lower value on price axis meaning the price of bonds decrease and the
consequent interest rate increase. In liquidity preference framework, mechanism is different but
result is the same. In that, money supply in system is decreased instead of increase in bond
supply in market. However, result is same, the interest rate go up.

6: Go to the St. Louis Federal Reserve FRED database and find data on net corporate dividend
payments (B056RC1A027NBEA). Adjust the units setting to “Percent Change from Year Ago,”
and download the data into a spreadsheet. a. Calculate the average annual growth rate of
dividends from 1960 to the most recent year of data available. b. Find data on the Dow Jones
Industrial Average (DJIA) for the most recent day of data available. Suppose that a $100
dividend is paid out at the end of next year. Use the Gordon growth model and your answer to
part (a) to calculate the rate of return that would be required for equity investment over the next
year, assuming you could buy a share of DJIA

a) In the excel we use average formula on the data, the value of average annual growth rate
comes to be 6.9%
 b) Latest dow jones value is 33874.85 , we use Gordon growth model for solving required
rate of return using : 33874.85 = 100/(ke – 0.069) ; hence Ke = 0.07195 or 7.195% is the
required rate of return.

7:Which relationship would you expect to exist between measures of corruption and living
standards at the country level ? Explain by which channel corruption might affect living
standards.

There is a clear inverse relation between corruption and living standards of a country. Living
standards of country can be measured in metrics like ease of doing legal work, ease of access in
government facilities, low interference of authority into personal life etc. Economically too
standard of living is depressed with corruption as less investment is attracted by the country both
from it’s own people oand by foreign funds as there is high red tapism and uncertainity for a
business to flourish, a company will not like to set up manufacturing or any business in an
envrionment where it is constantly threatened , asked to bribe and left to solve legal problems.
Since the overall investment is disturbed in the economy, per capita income and consequently
living standards are also weakened.

8:Would you recommend the adoption of a system of deposit insurance, like the FDIC in the
United States, in a country with weak institutions, prevalent corruption, and ineffective
regulation of the financial sector ?

No, it is not recommended. This is because the primary motive of any deposit insurance is to
provide a risk cover to the depositors in event of unforseen circumstances which wind down the
bank or the depsot raising institution. When there is high corruption and ineffective regulation
this will increase the moral hazard of inappropriate lending. It might lead to giving the credit to
non deserving borrowers by raising funds in garb of availability of deposit insurance.

9: Why have banks been losing cost advantages in acquiring funds in recent years ?

There are many reasons for this, one is competition. Earlier money market management was
highly concentrated in local banks but this rise of instruments like mutual funds in money
market, non banking financial institutions ,entry of foreign multinational banks and accessible
financial market instruments for the public like equity investment have all contributed in making
it more costly for banks to raise funds.
10. Define “financial frictions” in your own terms and explain why an increase in financial
frictions is a key element in financial crises.

Financial frictions imply condition where the efficient and effective allocation of funds is
disrupted due to any economic or non economic reason. It is a condition where right potential
borrowers are not identified and the fund flow is allocated in a maner it should not be. It is key
element in financial crises because flow of funds is critical in a finanical market, an interrupted
or potentially inefficient flow will lead to issue like mis-calculation of asset prices, rise in default
risk or uncertain fund flow environment among other potential issues, all of which make
condition for financial friction.

11: If the British central bank lowers interest rates to reduce unemployment, what will happen to
the value of the pound in the short run and in the long run ?

In short term the move creates inflation and makes Pound depreciate since there is more supply
of Pound in trade. The demand curve shifts to the left. In long run though unemployment comes
down and productivity in economy normally increases leading to appreciation in the value of
pound and thus softening the depreciation in the currency.

12 :Under the gold standard, if Britain became more productive relative to the United States,
what would happen to the money supply in the two countries ? Why would the changes in the
money supply help preserve a fixed exchange rate between the United States and Britain

Increase in productivity of Britain means it’s economy becomes more robust in value or output
terms. This naturally appreciates the currency (pound) with respect to lower productivity
economy like dollar. Us will exchange gold and dollars while sending gold to Britain , this will
lead to purchase of pounds by US using this gold resulting in increase in gold deposit of Britain.
Now since there is gold standard this means increase in money supply because of increase in
monetary base. This increased supply of money increases inflation and again pushes back
exchange rate to par level thus preserving more or less a fixed exchange rate.