Solutions Manual for The Econo mics o f Money, Banking, and Financial Markets Twelfth Edition Frederic S. Mishkin Copyright © 2019 by Pearson Education, Inc. All rights reserved. Chapter 1 ANSWERS TO QUESTIONS 1. What is the typical relationship among interest rates on three-month Treasury bills, long-
term Treasury bonds, and Baa corporate bonds? The interest rate on thre e-month Treasury b ills fluctuates more than th e other interest rates and is lower on average. The interest rate on B aa corporate bonds is highe r on average than the other interest rates. 2. What effect might a fa ll in stock prices ha ve on business investment? The lower price for a firm’s shares means that it can raise a smaller amount of funds, so investment in facilities and equipment will fall. 3. Explain the main difference be tween a bond and a common stock. A bond is a debt instrument, which entitles th e owner to receive pe riodic amounts of money (predetermined by the characteri stics of the bond) until its ma turity date. A common stock, however, represents a share of ownership in the institution that has issued the stock. In addition to its definition, it is not the same to hold bonds or stock of a given corporation, since regulations state th at stockholders are residual claimant s (i.e. the corporation has to pay all bondholders before paying stockholders). 4. Explain the link between well- performing financial markets and economic growth. Name one channel through which financial markets migh t affect economic growth and poverty. Well performing financial markets tend to allocat e funds to its more efficient use, thereby allowing the best investment opportunities to be undertaken. The improvement in the allocation of funds results in a more effici ent economy, which stimulates economic growth (and thereby poverty reduction). 5. What was the main cause of the recession that began in 2007? The United States’ economy was hit by the worst financial crisis since the Great Depression. Defaults in subprime residential mortgages le d to major losses in financial institutions, producing not only numerous bank failures but also the demise of two of the largest investment banks in the United States. These f actors led to the “Great Recession” that began late in 2007. Mishkin • Instructor’s Manual for The Economics of Money, Bank ing, and Financial Markets , Twelfth Edition 52 Copyright © 2019 by Pearson Education, Inc. All rights reserved. 6. Can you think of a reason why people in gene ral do not lend money to one another to buy a house or a car? How would your answe r explain the existence of banks? In general, people do not lend large amounts of money to one another because of several information problems. In particular, people do not know about the capacity of other people of repaying their debts, or the effort they will provi de to repay their debts. Financial intermediaries, in particular commercial banks, tend to solv e these problems by acquiring information about potential borrowers and writing an d enforcing contracts that encourage lenders to repay their debt and/or maintain the value of the collateral. 7. What are the other important financial inte rmediaries in the ec onomy, besides banks? Savings and loan associations, mutual savings banks, credit unions, insurance companies, mutual funds, pension funds, and finance companies. 8. Can you date the latest financial cr isis in the United States or in Europe? Are there reasons to think that these crises might have been related? Why? The latest financial crisis in the United States and Europe occurred in 2007–2009. At the beginning, it hit mostly the US financial system , but it then quickly moved to Europe, since financial markets are highly interconnected. One specific way in which these markets were related, is that some financial intermediaries in Europe held securities backed by mortgages originated in the United States, and when these securities lost their a considerable part of their value, the balance sheet of European fi nancial intermediaries was adversely affected. 9. Has the inflation rate in the United States in creased or decreased in the past few years? What about interest rates? From 2014 to mid-2017, inflat ion has been somewhat low, but increased more recently to near 2%; interest rates have m oved in a fairly narrow range, with the benchmark 10-year U.S. treasury rate moving from a high of around 2.5%, to as low as abou t 1.5% then increasing again. 10. If history repeats itself and we see a decline in the rate of money growth, what might you expect to happen to a. real output? b. the inflation rate? c. interest rates? The data in Figures 3, 5, and 6 suggest that real output, the inflation ra te, and interest rates would all fall. 11. When interest rates decrea se, how might businesses and c onsumers change their economic behavior? Businesses would increase investment spending b ecause the cost of financing this spending is now lower, and consumers would be more lik ely to purchase a house or a car because the cost of financing their purchase is lower. Mishkin • Instructor’s Manual for The Economics of Money, Bank ing, and Financial Markets , Twelfth Edition 53 Copyright © 2019 by Pearson Education, Inc. All rights reserved. 12. Is everybody worse off when interest rates rise? No. It is true that people who borrow to pur chase a house or a car are worse off because it costs them more to finance their purchase; however, savers benefit because they can earn higher interest rate s on their savings. 13. Why do managers of financial institutions care so much about the activities of the Federal Reserve System? Because the Federal Reserve affects interest rate s, inflation, and business cycles, all of which have an important impact on the prof itability of financial institutions. 14. How does the current size of the U.S. budget deficit compare to the historical budget deficit or surplus for the ti me period since 1950? The deficit as a percentage of GDP expanded dramatically in 2007 but improved starting in 2010; in 2009, the deficit to GDP ratio was 9.8%, and in 2016 was 3.2%, still above the historical average of around 2% since 1950. 15. How would a fall in the value of the pound sterling affect British consumers? It makes foreign goods more expensive, so British consumers will buy fewer foreign goods and more domestic goods. 16. How would an increase in the value of th e pound sterling affect American businesses? It makes British goods more expensive relative to American goods. Thus, American businesses will find it easier to sell their goods in the United States and abroad, and the demand for their products will rise. 17. How can changes in foreign exchange rates affect the profitability of financial institutions? Changes in foreign exchange rates change the value of assets held by financial institutions and thus lead to gains and losses on these assets . Also changes in foreign exchange rates affect the profits made by traders in foreign exchange who work for financial institutions. 18. According to Figure 8, in which years would you have chosen to visit the Grand Canyon in Arizona rather than the Tower of London? In the mid- to late 1970s, the late 1980s to early 1990s, and 2008 to 2015, the value of the dollar was low, making travel abroad relatively more expensiv e; thus, it was a good time to vacation in the United States and see the Grand Canyon. With the rise in the dollar’s value in the early 1980s, late 1990s, and after 2015, travel abroad beca me relatively cheaper, making it a good time to visit the Tower of London. This was also true, to a lesser extent, in the early 2000s.
