《货币银行学》课程授课教案（英文讲义）Chapter 06 The Economics of Financial Intermediation

Chapter6The Economics of Financial IntermediationChapter 6 The Economics of FinancialIntermediationProblems and Solutions1. Use the concept of adverse selection to explain why the value of a new cardrops as soon as you drive it off the dealer's lot.Answer: When you buy a new car from a dealer, you know the quality of the car youare purchasing.However, when buying a used car, it is difficult to distinguish goodcars from bad cars, so you will only be willing to pay the expected value of the car.Once you drive a new car out of the dealer's lot, it falls into the category of used cars.Even though the quality of the car hasn't changed and it is still just as good as a newcar,prospectivebuyers,because they can't be completely sure ofthe quality ofthe car,won't pay as much as if the car were “new."Describe the problem of asymmetric information that an employer faces in2.hiring a new employee.What solutions can you think of?Does theproblem persist after the person has been hired?If so, how? What can bedone about it?Is the problem more or less severe for employees on a fixedsalary?Why or why not?Answer:Prior to hiring a new employee, an employer may have difficulty identifyingcandidateswho would dothebest job.Aftersomeonehasbeenhired,theemployermaynotknowwhetherthatpersonis workinghard.Probationaryperiodswhen thenewemployeecanbeterminatedareasimplesolution,asaresalariesbasedonperformance.A fixed salary makes it difficult to create the proper incentives foremployees to do their best.3.In some cities, newspapers publish a weekly list of restaurants that have beencited for health code violations by local health inspectors.Whatinformation problem is this feature designed to solve? How?Answer: This solves both adverse selection and moral hazard.People who dine outatrestaurantsmayhaveadifficulttimeidentifyingrestaurantsthatdon'tmeet certainhealth standards.Because of this, some people may not want to eat out at all.Also,restaurants don't have an incentive to follow health regulations since diners can'tdistinguish restaurants that meet the health standards from those that don't.However, publishing the names of restaurants cited for health code violations allowspeople to identify unsanitary restaurants and thus holds restaurants accountable forfollowing health regulations.Instructor'sManualt/aCecchetti:Money,Banking,andFinancial Markets

Chapter 6 The Economics of Financial Intermediation Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets Chapter 6 The Economics of Financial Intermediation Problems and Solutions 1. Use the concept of adverse selection to explain why the value of a new car drops as soon as you drive it off the dealer’s lot. Answer: When you buy a new car from a dealer, you know the quality of the car you are purchasing. However, when buying a used car, it is difficult to distinguish good cars from bad cars, so you will only be willing to pay the expected value of the car. Once you drive a new car out of the dealer’s lot, it falls into the category of used cars. Even though the quality of the car hasn’t changed and it is still just as good as a new car, prospective buyers, because they can’t be completely sure of the quality of the car, won’t pay as much as if the car were “new.” 2. Describe the problem of asymmetric information that an employer faces in hiring a new employee. What solutions can you think of? Does the problem persist after the person has been hired? If so, how? What can be done about it? Is the problem more or less severe for employees on a fixed salary? Why or why not? Answer: Prior to hiring a new employee, an employer may have difficulty identifying candidates who would do the best job. After someone has been hired, the employer may not know whether that person is working hard. Probationary periods when the new employee can be terminated are a simple solution, as are salaries based on performance. A fixed salary makes it difficult to create the proper incentives for employees to do their best. 3. In some cities, newspapers publish a weekly list of restaurants that have been cited for health code violations by local health inspectors. What information problem is this feature designed to solve? How? Answer: This solves both adverse selection and moral hazard. People who dine out at restaurants may have a difficult time identifying restaurants that don’t meet certain health standards. Because of this, some people may not want to eat out at all. Also, restaurants don’t have an incentive to follow health regulations since diners can’t distinguish restaurants that meet the health standards from those that don’t. However, publishing the names of restaurants cited for health code violations allows people to identify unsanitary restaurants and thus holds restaurants accountable for following health regulations

Chapter6The Economics of Financial Intermediation4.In some countries it is very difficult for shareholders to fire managers whenthey do a poor job.What type of financing would you expect to find in thosecountries?Answer: When shareholders can't fire managers, people will be less willing topurchase equity because there is no way to discipline managers who fail to act in theinterests of the shareholders.Companies in those countries are more likely to issuebonds or seekbank loans to obtain funding5. Define the term economies of scale and explain how a financial intermediarycan take advantage of such economies.Answer: Economies of scale is when average costs fall as production increases.Byusing standardized forms for gathering information about potential borrowers and forissuingloans,financial intermediariescantakeadvantageofeconomiesofscale6.Explain theInternet'simpacton asymmetric informationproblemsa. How can the Internet help to solve information problems?b. Can the Internet compound some information problems?On which problem would the Internet have a greater impact, adversec.selection or moral hazard?Answer:The Internet provides people with a wealth of information, whether they area.evaluating a company before deciding whether to purchase its stock or doing a"Google" search on someone before going out on a date.b.Notall of the informationavailableisaccurate,which canmaketheproblemofadverseselectionworse.The Internet provides information to reduce adverse selection, but isn't veryc.helpful in reducing moral hazard.7. The financial sector is heavily regulated.Explain how governmentregulations help to solve information problems, increasing the effectiveness offinancial markets and institutions.Answer: The government requires firms to disclose information8.Define deflation and explain how it reduces the value of a borrower'scollateral.What is the effect on the information problems a lender faces?Answer:Deflation is a fall in the overall price level.A borrower's liabilities willremain the same, but the value of the borrower's assets will decline, decreasing thenet worthoftheborrower.Lenders usethenetworth of borrowersto overcomeinformation asymmetries; with a low net worth, it will be more difficult to borrow.Instructor'sManual t/aCecchetti:Money,Banking,andFinancial Markets

Chapter 6 The Economics of Financial Intermediation Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 4. In some countries it is very difficult for shareholders to fire managers when they do a poor job. What type of financing would you expect to find in those countries? Answer: When shareholders can’t fire managers, people will be less willing to purchase equity because there is no way to discipline managers who fail to act in the interests of the shareholders. Companies in those countries are more likely to issue bonds or seek bank loans to obtain funding. 5. Define the term economies of scale and explain how a financial intermediary can take advantage of such economies. Answer: Economies of scale is when average costs fall as production increases. By using standardized forms for gathering information about potential borrowers and for issuing loans, financial intermediaries can take advantage of economies of scale. 6. Explain the Internet’s impact on asymmetric information problems. a. How can the Internet help to solve information problems? b. Can the Internet compound some information problems? c. On which problem would the Internet have a greater impact, adverse selection or moral hazard? Answer: a. The Internet provides people with a wealth of information, whether they are evaluating a company before deciding whether to purchase its stock or doing a “Google” search on someone before going out on a date. b. Not all of the information available is accurate, which can make the problem of adverse selection worse. c. The Internet provides information to reduce adverse selection, but isn’t very helpful in reducing moral hazard. 7. The financial sector is heavily regulated. Explain how government regulations help to solve information problems, increasing the effectiveness of financial markets and institutions. Answer: The government requires firms to disclose information. 8. Define deflation and explain how it reduces the value of a borrower's collateral. What is the effect on the information problems a lender faces? Answer: Deflation is a fall in the overall price level. A borrower’s liabilities will remain the same, but the value of the borrower’s assets will decline, decreasing the net worth of the borrower. Lenders use the net worth of borrowers to overcome information asymmetries; with a low net worth, it will be more difficult to borrow

Chapter6TheEconomics ofFinancial Intermediation9. How can a sharp rise in interest rates reduce the creditworthiness of potentialborrowers?Answer: When the interest rate rises, potential borrowers who know they are a goodcredit risk won't be willing to borrow at the elevated rate, leaving only those who arebad credit risks.10.Many insurance companies insist on a physical examination before insuringapplicants for life insurance.Why do the companies collect this information?What might happen if they didn't?Answer: Companies collect this information because they don't want to insure peoplewho are probablygoing to die shortly.If companiesdidn'trequirephysical examsof applicants, then people with a high probability of dying soon would all purchaseinsurance.Companies would raise their premiums and healthy people wouldn'tbuyinsurance.11. In 2002 the trustworthiness of corporate financial reporting was called intoquestion when a number of companies corrected their financial statementsfor past years.What impact did their action have on the financial markets?Answer: Investors became less sure of their ability to distinguish good firms from badones, so their willingness to purchase stocks and bonds decreased.12.Firms in some sectors of the economy have moreleverage than firms in otherparts. Explain how differences in businesses might create such differences inleverage.Answer:Sectors where information problems are worst will have the hardest timeobtaining funds.Firms where output and performance aredifficult to observe, suchas small consulting businesses, will find it very difficult to borrow or issue stock.By contrast, companies with easy to observe output and effort, such a smallmanufacturing firms, will find borrowing easier.13. Would you be happy or unhappy if a company whose stock you owned wasbought by a leveraged buyout specialist who financed the purchase with junkbonds?Why?Answer: If the buyer paid a high price and purchased my stock, I would be happy. If,instead, left me holding stock, then that stock will be much more risky, and I wouldbe unhappy.I would also be unhappy because I would not have information aboutthe new owner.Instructor'sManual t/aCecchetti:Money,Banking,andFinancial Markets

Chapter 6 The Economics of Financial Intermediation Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 9. How can a sharp rise in interest rates reduce the creditworthiness of potential borrowers? Answer: When the interest rate rises, potential borrowers who know they are a good credit risk won’t be willing to borrow at the elevated rate, leaving only those who are bad credit risks. 10. Many insurance companies insist on a physical examination before insuring applicants for life insurance. Why do the companies collect this information? What might happen if they didn’t? Answer: Companies collect this information because they don’t want to insure people who are probably going to die shortly. If companies didn’t require physical exams of applicants, then people with a high probability of dying soon would all purchase insurance. Companies would raise their premiums and healthy people wouldn’t buy insurance. 11. In 2002 the trustworthiness of corporate financial reporting was called into question when a number of companies corrected their financial statements for past years. What impact did their action have on the financial markets? Answer: Investors became less sure of their ability to distinguish good firms from bad ones, so their willingness to purchase stocks and bonds decreased. 12. Firms in some sectors of the economy have more leverage than firms in other parts. Explain how differences in businesses might create such differences in leverage. Answer: Sectors where information problems are worst will have the hardest time obtaining funds. Firms where output and performance are difficult to observe, such as small consulting businesses, will find it very difficult to borrow or issue stock. By contrast, companies with easy to observe output and effort, such a small manufacturing firms, will find borrowing easier. 13. Would you be happy or unhappy if a company whose stock you owned was bought by a leveraged buyout specialist who financed the purchase with junk bonds? Why? Answer: If the buyer paid a high price and purchased my stock, I would be happy. If, instead, left me holding stock, then that stock will be much more risky, and I would be unhappy. I would also be unhappy because I would not have information about the new owner

Chapter6TheEconomicsof Financial Intermediatior14.Would you expectthelemons problemtobemore or less severeintheemerging markets countries of Latin America, Eastern Europe, and Asiathan in the major industrialized countries?Why or why not?Does youranswerdepend on the stability of the countries'political regimes?Answer: The lemons problem is more severe in emerging markets countries becausethere is not as much accurate information available about firms.The stability of thecountries political regimes is important because government required disclosure ofinformationcanhelpreducethelemonsproblem15. While it is possible to obtain medical insurance as an individual, it is cheaperto get it as part of a large group through your employer.Why?Answer: When obtaining insurance as an individual, the insurer has no idea about therisk, and charges a high price.That is, the insurance company assumes you are alemon.In the case of a large employer, the insurance company can measure thelikely payout associated with the group.That information allows the premium tofall.Instructor's Manual t/aCecchetti:Money,Banking,andFinancial Markets

Chapter 6 The Economics of Financial Intermediation Instructor’s Manual t/a Cecchetti: Money, Banking, and Financial Markets 14. Would you expect the lemons problem to be more or less severe in the emerging markets countries of Latin America, Eastern Europe, and Asia than in the major industrialized countries? Why or why not? Does your answer depend on the stability of the countries’ political regimes? Answer: The lemons problem is more severe in emerging markets countries because there is not as much accurate information available about firms. The stability of the countries’ political regimes is important because government required disclosure of information can help reduce the lemons problem. 15. While it is possible to obtain medical insurance as an individual, it is cheaper to get it as part of a large group through your employer. Why? Answer: When obtaining insurance as an individual, the insurer has no idea about the risk, and charges a high price. That is, the insurance company assumes you are a lemon. In the case of a large employer, the insurance company can measure the likely payout associated with the group. That information allows the premium to fall