Economics 330

Money and Banking

Answers to Handout #3

I. See book

II. 1. F

2. F

3. F: adverse selection occurs before the transaction.

4. F: see car market example.

5. F: see definition of moral hazard.

6. F: this is moral hazard.

7. Uncertain: it may create a moral hazard with regard to consumers of the item since the item may not be made as carefully.

8. F: banks keep the information they collect private.

9. F: the principal-agent problem easily arises with equity contracts since managers may not always act in the owner’s best interests.

10. Uncertain: costly state verification refers to the monitoring of the firm’s activities and management by the firm’s owners. Costly state verification might not occur at the optimal level due to the free rider problem.

11. F: look at what happened to the S&Ls.

12. T

13. T: as net worth decreases the owners of the company have an incentive to increase their risk taking.

14. T

15. T

16. F: financial innovation can also occur as a response to changes in supply conditions as well as an effort to avoid regulations.

17. F: check the definition.

18. T

19. F

20. F: the sources of funds is the liabilities side of the bank’s balance sheet.

21. T

22. Uncertain: liquidity management includes this as well as other methods of handling deposit outflows.

III. 1. This is a question about asymmetric information: it particularly pertains to the problem of moral hazard as exemplified in the principal-agent problem.

2. Incentives provided by deposit insurance, financial innovations or the avoidance of regulatory standards could be discussed in this answer.

3. Your book gives a very thorough coverage of both the definition of the free rider problem as well as illustrations of it.

4. Competition is not necessarily achieved by the sheer presence of large numbers of banks particularly if each bank provides financial services only to a limited geographic region. In the extreme case a large number of banks might be indicative of a monopolistic situation. The U.S. banking system evolved in its manner because of the haphazard development of the frontier and the general cultural suspicion of centralized financial power.

5. Again the book covers this general topic well. After defining these goals then your answer should reflect on how these goals might not be simultaneously possible.