Financial Markets
1. How can the adverse selection problem explain why you are more likely to make a loan to a family member than to a stranger?
Because you know your family member better than a stranger, you know more about the borrower’s honesty, propensity for risk taking, and other traits. There is less asymmetric information than with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member.
2. If mortgage rates rise from 5% to 10%, but the expected rate of increase in housing prices rises from 2% to 9%, are people more likely or less likely to buy houses? Explain you answer.
People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3 percent (5 percent –2 percent) to 1 percent (10 percent –9 percent). The real cost of financing the house is thus lower, even though mortgage rates have risen. (If the tax deductibility of interest payments is allowed for, then it becomes even more likely that people will buy houses.)
3. Using the supply and demand for bonds framework, explain and show why interest rates are procyclical (rising when the economy is expanding and falling during recessions).
When the economy booms, the demand for bonds increases: the public’s income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves (Bd and Bs) shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises. Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the bond price rises and the interest rate falls. The conclusion is that bond prices fall and interest rates rise during booms and fall during recessions: that is, interest rates are procyclical.
4.
Because you know your family member better than a stranger, you know more about the borrower’s honesty, propensity for risk taking, and other traits. There is less asymmetric information than with a stranger and less likelihood of an adverse selection problem, with the result that you are more likely to lend to the family member.
2. If mortgage rates rise from 5% to 10%, but the expected rate of increase in housing prices rises from 2% to 9%, are people more likely or less likely to buy houses? Explain you answer.
People are more likely to buy houses because the real interest rate when purchasing a house has fallen from 3 percent (5 percent –2 percent) to 1 percent (10 percent –9 percent). The real cost of financing the house is thus lower, even though mortgage rates have risen. (If the tax deductibility of interest payments is allowed for, then it becomes even more likely that people will buy houses.)
3. Using the supply and demand for bonds framework, explain and show why interest rates are procyclical (rising when the economy is expanding and falling during recessions).
When the economy booms, the demand for bonds increases: the public’s income and wealth rises while the supply of bonds also increases, because firms have more attractive investment opportunities. Both the supply and demand curves (Bd and Bs) shift to the right, but as is indicated in the text, the demand curve probably shifts less than the supply curve so the equilibrium interest rate rises. Similarly, when the economy enters a recession, both the supply and demand curves shift to the left, but the demand curve shifts less than the supply curve so that the bond price rises and the interest rate falls. The conclusion is that bond prices fall and interest rates rise during booms and fall during recessions: that is, interest rates are procyclical.
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