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ECO 4223 Exam 2: Questions & Verified Answers
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ECO 4223 Exam 2: Questions & Verified Answers
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ECO 4223 Exam 2: Questions & Verified Answers Interest spread Correct Ans - the difference between the interest paid and interest earned.Interest spread example Correct Ans - a bank pays a 1.5% savings rate to
lenders but charges a 4.5% rate for a 30 year mortgage to borrowers. What is the interest spread? 3%
How is interest spread determined? Correct Ans - Market forces, when prices are above or below equilibrium. (Shortage of funds or surplus of funds).
Downward pressure on prices (surplus) and upward pressure on interest rates. (Shortage)
What happens if there is a surplus in interest spread? Correct Ans - Downward pressure on prices
What happens if there is a shortage in interest spread? Correct Ans - Upward pressure on interest rates
Different types of loans a bank offers Correct Ans - Commercial and residential mortgages, car loans, student loans, interbank lending, personal loans
Asymmetric information Correct Ans - When one agent has more information than the other agent
Two types of asymmetric information? Correct Ans - Adverse selection and moral hazard
Adverse selection Correct Ans - Adverse selection occurs when individuals select into a program and the program mistakenly only attracts the riskiest of agents.
For insurance to work properly... Correct Ans - underwriters must price in the value of the contract the probabilities of insureds filing claims. This could lead to an underestimation of claims frequencies, resulting in large losses to the insurer. How to counter adverse selection Correct Ans - Create a plan where the risky individuals are just as likely to sign up for insurance or lending as the less risky individuals.
How did state farm and other try to counter adverse selection. What is the problem with this? Correct Ans - Progressive, State Farm, and Others have tried to solve this adverse selection problem by distinguishing between types of individuals using their safe driving program discount. The idea is that the device will record their driving behaviors and the data will tell whether they are safe or not. The insurance company can then offer a discount if safer or the higher amount if riskier.
Moral Hazard
Moral Hazard Correct Ans - Moral hazard occurs when individuals change their behavior based on the incentives in the contract or relationship. It is an ex-post feature.
Causes of Housing market crisis Correct Ans - 1.Federal Reserve interest rate policy (Lower rates, higher housing prices)
2.Adjustable Rate Mortgages (ARM) offered "teaser" rates
3.Government policies to promote home ownership (Community reinvestment act (CRA))
4.Secondary Mortgage Market
5.Repeal of Glass Steagall Act of 1933
6.Little to no Collateral
7.Overconfidence that housing prices would continually rise
ARMs contribution to housing crisis Correct Ans - ARMs offered teaser rates and sometimes "interest only" loans. These loans were cheaper for subprime borrowers, but they reset after a few years. This was okay as long as
housing prices continued to increase. Then, they could resell the house and profit. When prices declined....
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