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First Exam

First Exam. Econ 311 Money and Banking. Consider how expectations about the future can affect current behavior.

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First Exam

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  1. First Exam Econ 311 Money and Banking

  2. Consider how expectations about the future can affect current behavior. • Use the graph on the next page and draw a person’s inter-temporal budget constraint if he earns $100,000 today and expects to earn $100,000 in the future. Draw indifference curves if the person prefers to even out his consumption so that he consumes the same amount today and in the future. • Suppose the person receives a layoff notice and expects to lose his job in the future. Modify your inter-temporal budget constraint and use indifference curves to show how this will affect current and future consumption and savings and borrowing if the interest rate is 10% and when he gets laid off he will receive unemployment benefits equal to 25% of his pay. • Suppose the person doesn’t receive a layoff notice but the economy in general enters a recession and he realizes that there is a reasonable chance he will get laid off in the future. Depict the inter-temporal budget constraint for this situation and compare and contrast the effect on current consumption with your answer to (2). • Suppose the government passes a “jobs” bill which will increase or extend unemployment benefits. Depict the effect of such a “jobs” bill on your graph. Will this type of jobs bill increase or decrease the unemployment rate? Explain. Even Consumption $100K Reasonable Chance Expects to get laid off $25K $100K Consumption today

  3. Price of Bonds Interest Rate Quantity of Bond Quantity of Money • An increase in the money supply will cause an increase in expected inflation (Fisher Effect). • If expected inflation increases, the expected return on bonds relative to real assets falls for any given bond price and interest rate. As the result the demand for bonds falls (B1 to B2). • The rise in expected inflation also shifts the supply curve. At any given bond price and interest rate, the real cost of borrowing has declined causing the quantity of bonds supplied to increase and the supply curve shifts to the right (B1 to B2). • The price of bonds will fall from P1 to P2 causing nominal interest rates to rise. • An increase in the money supply will shift the supply of money to the right. Everything else being equal, interest rates will fall. • Income Effect: the increase in the money supply increases output and wealth leading to an increase in demand for money. • Price-Level Effect: the increase in the money supply will cause the price level to increase leading to an increase in the demand for money. • Expected Inflation Effect: the increase in the money supply causes people to expect higher inflation and an increase in the demand for money. MS1 MS2 BS1 BS2 P1 MD2 P2 BD1 MD1 BD2

  4. Question 3 • Consider the Asymmetric information explored in the in-class experiment. • What is an asymmetric information problem? Give an example. • Can the free market solve the asymmetric information problem or is government regulation and interference necessary? • How might this apply to the efficient operation of financial markets? Explain and discuss. • An asymmetric information problem arises when one party to a transaction has better information about the quality of a good being exchanged than the other party. • The free market can solve the asymmetric information problem by providing a mechanism for assuring the quality of a good. • Branding. • Warranty. • Return Policy • This applies to financial markets because when lending money one party has better information about the likelihood of default than another party.

  5. Question 4 • Consider the following article about oil prices. • What is the article saying about the relationship between the optimal forecast and the expected return on buying and holding oil? • Suppose you invested in such a way that you would make money if the price of oil fell below $75 a barrel. Is this a wise investment given the information in the article? • Discuss in light of the Theory of Rational Expectations and the Efficient Market Hypothesis. • The theory of rational expectations posits that market prices incorporate the best information and forecast about the future. • So if the market price is $81.25. there can be no expected profit from speculating the price of oil will rise or fall.

  6. The Curve

  7. Administrative Details. • There will be a mandatory one week cooling off period for any and all questions about the exam. After one week, if you want to discuss your exam you must come by office hours.

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