PROBLEMS AND APPLICATIONS

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Question 20.8

1. In each of the following cases, identify whether the problem is adverse selection or moral hazard, and explain your answer. How might the problem be dealt with?

  1. Rick has gotten a large advance to write a textbook. With the money in hand, he prefers spending his time sailing rather than sitting in his office working on the book.

  2. Justin is trying to get a large advance to write a textbook. He knows, but publishers don’t, that he did poorly on the writing portion of the SAT.

  3. Mai is buying a life insurance policy. She knows that members of her family tend to die young.

  4. Erich, who has a large life insurance policy, spends his vacation pursuing his favorite hobbies: skydiving, bungee jumping, and bullfighting.

Question 20.9

2. Nation A has a well-developed financial system, where resources flow to the capital investments with the highest marginal product. Nation B has a less-developed financial system from which some would-be investors are excluded.

  1. Which nation would you expect to have a higher level of total factor productivity? Explain. (Hint: See the appendix to Chapter 9 for the definition of total factor productivity.)

  2. Suppose that the two nations have the same saving rate, depreciation rate, and rate of technological progress. According to the Solow growth model, how does output per worker, capital per worker, and the capital–output ratio compare in the two countries?

  3. Assume the production function is Cobb–Douglas. Compare the real wage and the real rental price of capital in the two countries.

  4. Who benefits from having a better-developed financial system?

Question 20.10

3. Some commentators argue that when a financial firm is rescued by the government in the midst of a financial crisis, the firm’s equity holders should be wiped out, but the firm’s creditors should be protected. Does this solve the moral hazard problem? Why or why not?

Question 20.11

4. In recent years, as described in this chapter, both the United States and Greece have experienced increases in government debt and a significant economic downturn. In what ways were the two situations similar? In what ways were they different? Why did the two nations have different policy options at their disposal?

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1 Trivia fact: This story is not entirely fictional. The author really does know a Patti who started a doll business and a Larry who financed it.

2 Throughout this chapter, the word bank should normally be taken to mean commercial bank, which is the most familiar type of bank. By contrast, an investment bank is a financial institution that assists firms and governments in the issuance of stocks and bonds, as well as performing several other functions such as helping arrange corporate mergers and acquisitions. Investment banks not only serve different functions from commercial banks but, because they do not accept insured deposits, are also subject to less regulatory oversight.

3 The source of the quotation is http://www.grameenfoundation.org/what-we-do/microfinance-basics. For more on this topic, see Beatriz Armendáriz and Jonathan Morduch, The Economics of Microfinance (Cambridge, MA: MIT Press, 2007).

4 To read more about the history of financial crises, see Charles P. Kindleberger and Robert Z. Aliber, Manias, Panics, and Crashes: A History of Financial Crises, 2nd ed. (New York: Palgrave Macmillan, 2011); and Carmen M. Reinhart and Kenneth S. Rogoff, This Time Is Different: Eight Centuries of Financial Folly (Princeton, NJ: Princeton University Press, 2009).

5 For more on macroprudential policy, see Stijn Claessens, “An Overview of Macroprudential Policy Tools,” IMF Working Paper, December 2014.

6 To learn more about this topic, see Philip R. Lane, “The European Sovereign Debt Crisis.” Journal of Economic Perspectives, 26(3), Summer 2012: 49–68.