Preparing for Exam 2

Important

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Warning

This is not an exhaustive list of questions or even topics. You still need to review all material and it would be a good idea to create your own questions to try to answer.

Consumption

  1. How do short-run changes in income affect consumption decisions according to forward-looking theories? Discuss the implications of this on the consumption function’s responsiveness to income changes.

  2. What do forward looking consumption theories imply about the size of the multiplier for government stimulus?

  3. What is the “market for lemons” problem, and how does it relate to credit rationing in financial markets? Provide an example to illustrate this concept.

  4. How does imperfect information in credit markets lead to the demand for equity or collateral from borrowers?

  5. What does credit rationing imply for the forward-looking consumption theories?

Investment

  1. Discuss the sources of funds that businesses can use to finance their investment projects.

  2. Calculate the present value of a $10,000 payment in 10 years, assuming the relevant interest rate is 5%.

  3. Discuss the concept of “hurdle rates” and their role in investment projects. How do hurdle rates impact a firm’s investment decisions, and do they tend to move in line with current interest rates?

  4. Why might the cost of borrowing increase the more a firm borrows for investment projects?

  5. Why do measures of firm cash flow/current income seem to be so closely related to investment expenditures?

  6. In what sense do interest rates represent a cost to a firm even if it uses retained earnings to finance investment?

  7. Suppose you want to realize a future value of $150,000 in 30 years on an investment you make. The average annual rate of return is 8.75%. What will be the present value of your investment?

  8. Why might firms prefer using internal funds (retained earnings) as opposed to issuing equity when financing an investment project?

  9. Why might firms prefer using debt to equity when financing an investment project?

Money and Banking

  1. Explain how banks create money when they make loans. Why is it incorrect to believe that banks lend out money that others have deposited with them?

  2. Using balance sheets, illustrate the process of money creation by a bank when it grants a mortgage. Include the changes in assets and liabilities for both the bank and the borrower.

  3. Describe the process of interbank transactions when a buyer and seller use different banks for a financial transaction. Include the concept of settlement assets and reserves.

  4. For each of the following discuss what functions of money they serve and for whom:

    1. Reserves
    2. Treasuries
    3. Fiat currency
    4. Bank deposits

  5. Explain why a bank might need to sell assets during a liquidity crisis. What challenges might the bank face when trying to sell illiquid assets?

  6. Explain the relationship between a bank’s leverage ratio and its risk of insolvency. How does a higher leverage ratio impact a bank’s profitability and its vulnerability to financial crises?

  7. What is the difference between bank solvency and bank liquidity problems? How are they related?

  8. Discuss the liquidity of an asset or liability.

Monetary policy

  1. Discuss the changes in monetary policy practices that occurred after the financial crisis of 2008-2009.

  2. Right now, the federal reserve is increasing interest rates to bring down inflation. Describe how this works to a friend who has not taken an economics class. Be sure to describe the causal chain as precisely as possible.

  3. Describe the organizational structure of the Federal Reserve System.

  4. Define the Federal Reserve’s dual mandate.

Interest rates facing borrowers

  1. Explain the concept of interest rate premia and how it is used to account for risk when setting interest rates on loans. Discuss the factors that may lead to an increase in interest rate premia.

  2. Explain the elements of our final interest rate equation: \(r= (𝑖−𝜋^𝑒+𝑥)\)

IS-MP

  1. What factors cause the IS curve to shift?

  2. What factors would change the slope of the IS curve?

  3. Would monetary policy be more effective if the IS curve were steeper or flatter?

  4. Discuss (in detail!) the effect of a decline in interest rates on:

    1. Consumption
    2. Investment
    3. Net Exports

  5. Show the effect on the IS-MP framework if there is a credit crunch the economy, meaning banks are unwilling to lend except at high interest rates.

  6. Describe the factors that could cause the MP curve to shift.