02 Jun Question Econ 451 Fall 2014
Question
Econ 451
Fall 2014
Homework 1
Instructions:
? You need to use the concepts and theories we discussed in class to answer the
questions.
? Use bullet-point style to outline your arguments.
1. Suppose you go to a bank, intending to buy a one-year certificate of deposit that pays an
annual interest rate of 2% with your savings. At the bank, you run into a stranger who
happens to be at the bank applying for a car loan which the bank charges him an annual
interest rate of 8%. Give two reasons why you would not offer a loan to the car loan
applicant that would significantly increase the return of your savings (close to 8%).
Assume that your savings are sufficient to cover his car loan.
2. What is the adverse selection problem on the corporate bond market?
3. (a) What is the net worth of a firm?
(b) Explain why the net worth of a potential borrower can be used to overcome both
the adverse selection and moral hazard problem for a loan.
4. A central bank serves as the “lender of last resort” for the commercial banks by offering
additional funding to troubled banks. Explain how this extra insurance can exacerbate
the moral hazard problem in the banking industry. (Note that you need to explain the
moral hazard problem without the central bank, and why the problem is worse with
access to the central bank’s lending.)
5. You are hiring Bob to manage your business. If Bob works hard, the business would yield
an expected net profit of $30,000. If Bob is lazy, the business would yield an expected
net profit of $20,000. You do not observe if Bob works hard or not, nor you can infer
from the actual net profit if Bob has worked hard or not since the business is inherently
risky. Bob view working hard as a “personal cost” valued at $1,000. Assume Bob cares
only about his expected payment less any “personal cost.”
(a) Would offering Bob an additional $1,000 in pay sufficient to induce him to work
hard? Why?
(b) How about offering Bob a fixed percentage of profit? If the answer is yes, what is the
minimum percentage you should offer to induce him to work hard? Explain.
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