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Chapter 2: Q.8 (page 97)
The U.S. economy borrowed heavily from the British in the nineteenth century to build a railroad system. Why did this make both countries better off
Heavy interest rate lead to the improvement in both the nations.
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A significant number of European banks held large amounts of assets as mortgage-backed securities derived from the U.S. housing market, which crashed after 2006. How does this demonstrate both a benefit and a cost to the internationalization of financial markets?
Suppose you have just inherited \(10,400 and are considering the following options for investing the money to maximize your return:
Option 1: Put the money in an interest-bearing checking account that earns 3%. The FDIC insures the account against bank failure.
Option 2: Invest the money in a corporate bond with a stated return of 6%, although there is a 10% chance the company could go bankrupt.
Option 3: Loan the money to one of your friend鈥檚 roommates, Ayesha, at an agreed-upon interest rate of 7%, but you believe there is a 7% chance that she will leave town without repaying you.
Option 4: Hold the money in cash and earn zero return.
a. If you are risk-neutral (that is, neither seek out nor shy away from risk), which of the four options should you choose to maximize your expected return? (Hint: To calculate the expected return of an outcome, multiply the probability that an event will occur by the outcome of that event and then add them up.)
b. Assume that Option 3 and Option 4 are your only choices. If you could pay your friend \)50 to find out extra information about Ayesha that would indicate with certainty whether she will leave town without paying, would you pay the $50? What does this say about the value of better information regarding risk?
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?
If there were no asymmetry in the information that a borrower and a lender had, could a moral hazard problem still exist?
How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger?
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