Principles of
Macroeconomics
Problem Session-2
by
Research Assistant
Serkan Deirmenci
15.03.2012
Today
Mankiw (2008), Principles of
Economics:
- Chapter 27: The Basic Tools of
Finance: (pages: 597-612)
Questions for Review (QfR): 1-7 (page: 611)
Problem and Applications (P&A): 1-11 (page:
611-612)
- Chapter 29: The Monetary System:
Questions for Review: 1-2-3-4-5-6-7-8-9 (page:
660)
Problems and Applications: 2-3-4-5-6-7-8-9-10-11-
12-13 (page: 660-661)
Chapter 27: QfR-1 (page:
611)
The interest rate is 7 percent. Use the concept of
present value to compare $200 to be received
in 10 years and $300 to be received in 20 years.
ANSWER:
If the interest rate is 7%,
the present value of $200 to be received in
10 years is $200/(1.07)10 = $101.67.
If the interest rate is 7%,
the present value of $300 to be received 20
years from now is $300/(1.07)20 = $77.53.
Chapter 27: QfR-2 (page:
611)
What benefit do people get from the market for
insurance? What two problems impede the
insurance company from working perfectly?
ANSWER:
Purchasing insurance allows an individual to
reduce the level of risk he faces.
Two problems that impede the insurance industry
from working correctly are adverse selection
and moral hazard. Adverse selection occurs
because a high-risk person is more likely to apply
for insurance than a low-risk person is.
Moral hazard occurs because people have less
incentive to be careful about their risky behavior
after they purchase insurance.
Chapter 27: QfR-3 (page:
611)
What is diversification? Does a stockholder get
more diversification going from 1 to 10 stocks or
going from 100 to 120 stocks?
ANSWER:
Diversification is the reduction of risk achieved by
replacing a single risk with a large number of
smaller unrelated risks.
A stockholder will get more diversification going
from 1 to 10 stocks than from 100 to 120 stocks.
(see Figure 2 on page 604)
611)
Comparing stocks and government bonds,
which has more risk? Which pays a higher
average return?
ANSWER:
Stocks have more risk because their value
depends on the future value of the firm.
Because of its higher risk, shareholders will
demand a higher return.
There is a positive relationship between risk and
return.
Chapter 27: QfR-5 (page:
611)
What factors should a stock analyst think about in
determining the value of a share of stock?
ANSWER:
A stock analyst will consider the future
profitability of a firm when determining the
value of the stock.
Chapter 27: QfR-6 (page:
611)
Describe the efficient markets hypothesis and
give a piece of evidence consistent with this
hypothesis.
ANSWER:
The efficient markets hypothesis suggests that
stock prices reflect all available
information.
This means that we cannot use current
information to predict future changes in
stock prices.
One piece of evidence that supports this theory is
the fact that many index funds outperform
mutual funds that are actively managed by
a professional portfolio manager.
Chapter 27: QfR-7 (page:
611)
Explain the view of those economists who are
skeptical of the efficient market hypothesis.
ANSWER:
Economists who are skeptical of the efficient
markets hypothesis believe that fluctuations in
stock prices are partly psychological.
People may in fact be willing to purchase a stock
that is overvalued if they believe that someone
will be willing to pay even more in the future.
This means that the stock price may not be a
rational valuation of the firm.
Chapter 27: P&A-1 (page: 611)
Your bank account pays an interest rate of 8
percent. You are considering buying a share of
stock in XYZ Corporation for $110. After 1,2, and
3 years, it will pay a dividend of $5. You expect to
sell the stock after 3 years for $120. Is XYZ a
good investment? Support your answer with
calculations.
ANSWER:
The value of the stock is equal to the present
value of its dividends and its final sale price.
This is equal to $5/1.08 + $5/(1.08)2 + ($5 +
$120)/(1.08)3 = $4.63 + $4.29 + $99.23 =
$108.15.
Since this is lower than the initial selling
price of $110, XYZ stock is not a good
Chapter 27: P&A-2 (page: 611)
According to an old myth, Native
Americans sold the island of
Manhattan about 400 years ago for
$24. If they had invested this amount
at an interest rate of 7 percent per
year, how much would they have
today?
ANSWER:
The future value of $24 invested for
400 years at an interest rate of 7% is
(1.07)400 $24 =
Chapter 27: P&A-3 (page: 612)
A company has an investment project that would cost $10 million today and yield a
payoff of $15 million in 4 years.
a. Should the firm undertake the project if the interest rate is 11 percent? 10 percent?
9 percent? 8 percent?
b. Can you figure out the exact cutoff for the interest rate between the profitability
and nonprofitability?
ANSWER:
a. The present value of $15 million to be received in four years at an interest rate of 11% is $15
million/(1.11)4 = $9.88 million. Because the present value of the payoff is less than the
cost, the project should not be undertaken.
The present value of $15 million to be received in four years at an interest rate of 10% is $15
million/(1.10)4 = $10.25 million. Because the present value of the payoff is greater than
the cost, the project should be undertaken.
The present value of $15 million to be received in four years at an interest rate of 9% is $15 million/
(1.09)4 = $10.63 million. Because the present value of the payoff is greater than the cost,
the project should be undertaken.
The present value of $15 million to be received in four years at an interest rate of 8% is $15 million/
(1.08)4 = $11.03 million. Because the present value of the payoff is greater than the cost,
$10 15 /(1 x )4
the project should be undertaken.
b. The exact cutoff for the interest rate10(1 x )4 profitability
between 15 and nonprofitability is the interest rate
(1 x )4
that will equate the present value of receiving 1.5
$15 million in four years with the current cost of the
project ($10 million): 1 x (1.5)0.25
1 x 1.1067
x 0.1067
Chapter 27: P&A-4 (page: 612)
For each of the following kinds of insurance, give
an example of behavior that can be called moral
hazard and another example of behavior that
can be called adverse selection.
a. health insurance
b. car insurance
ANSWER:
a. A sick person is more likely to apply for
health insurance than a well person is. This
is adverse selection. Once a person has
health insurance, he may be less likely to
take good care of himself. This is moral
hazard.
b. A risky driver is more likely than a safe
driver to apply for car insurance. This is
Chapter 27: P&A-5 (page: 612)
Imagine that the U.S. Congress, recognizing the importance of being well dressed, started
giveing preferential tax treatment to clothing insurance. Under this new type of insurance,
you would pay the insurance company an annual premium, the insurance company would
than pay for 80 percent of your clothing expenses (you pay the remaining 20 percent), and
the tax laws would partly subsidize your insurance premiums.
a. How would the existence of such insurance affect the amount of clothing that people buy?
How would you evaluate this change in behavior from the standpoint of economic efficiency?
b. Who would choose to buy clothing insurance?
c. Suppose that the average person now spends $2000 a year on clothes. Would clothing
insurance cost more or less than $2000? Explain.
d. In your view, is this congressional action a good idea? How would you compare this idea
with the current tax treatment of health insurance?
ANSWER:
a. The insurance would increase the amount that individuals spend on clothing. The amount
of clothing purchased would likely be greater than the efficient level, because those making
the purchase decisions are not paying the entire cost.
b. Individuals who desire or need to spend a lot on clothing will be those most likely to buy
clothing insurance.
c. Clothing insurance will cost more than $2,000. Only those who spend more than average
will want to purchase the insurance. The insurance company will have to set the premium
such that it covers expected losses and administrative costs. Due to the adverse selection
problem, the insurance company will end up providing insurance for those who will spend
more than $2,000 per year on clothing. Thus, the premium will have to be greater than
$2,000.
d. No, this is not a good idea. It leads to overspending on clothing. This issue is very different
from health insurance, because purchases of medical care can often be life-or-death
decisions. In addition, increases in health lead to higher productivity so total output in the
economy can be affected by improvements in health. Last, there may be positive
Chapter 27: P&A-6 (page: 612)
Imagine that you intend to buy a
portfolio of ten stocks with some of
your savings. Should the stocks be of
companies in the same industry?
Should the stocks be of companies
located in the same country? Explain.
ANSWER:
To reduce the risk associated with
the portfolio, it is better to
diversify.
This means that the stocks
Chapter 27: P&A-7 (page: 612)
Which kind of stock would you expect
to pay the higher average return:
stock in an industry that is very sensitive
to economic conditions (such as an
automaker) or stock in an industry that is
relatively insensitive to economic
conditions (such as a water company)?
Why?
ANSWER:
A stock that is very sensitive to
economic conditions will have more
risk associated with it. Thus, we
would expect for that stock to pay a
Chapter 27: P&A-8 (page: 612)
A company faces two kinds of risk. A firm-
specific risk is that a competitor might
enter its market and take some of its
customers. A market risk is that the
economy might enter a recession,
reducing sales. Which of these two
risks would more likely cause the
companys shareholders to demand a
higher return? Why?
ANSWER:
Shareholders will likely demand a
higher return due to the stocks firm-
specific risk. Firm-specific risk is risk that
Chapter 27: P&A-9 (page: 612)
You have two roommates who invest in the stock market.
a. One roommate says that he buys stock only in companies that
everyone believes will experience big increases in profits in the
future. How do you suppose the price-earnings ratio of these
companies compares to the price-earnings ratio of other
companies? What might be the disadvantage of buying stock in
these companies?
b. Another roommate says he only buys stock in companies that
are cheap, which he measures by a low price-earnings ratio. How
do you suppose the earnings prospects of these companies
compare to those of other companies? What might be the
disadvantage of buying stock in these companies?
ANSWER:
a. If a roommate is buying stocks in companies that everyone
believes will experience big profits in the future, the price-earnings
ratio is likely to be high. The price is high because it reflects
everyones expectations about the firms future earnings. The
largest disadvantage in buying these stocks is that they are
currently overvalued and may not pay off in the future.
b. Firms with low price-earnings ratios will likely have lower future
Chapter 27: P&A-10 (page: 612)
When company executives buy and sell stock based on private
information they obtain as part of their jobs, they are engaged in
insider trading.
a. Give an example of inside information that might be useful for
buying and or selling stock.
b. Those who trade stocks based on inside information usually
earn very high rates of return. Does this fact violate the efficient
markets hypothesis?
c. Insider trading is illegal. Why do you suppose that is?
ANSWER:
a. Answers will vary, but may include things like information on
new products under development or information concerning future
government regulations that will affect the profitability of the firm.
b. The fact that those who trade stocks based on inside
information earn very high rates of return does not violate the
efficient markets hypothesis. The efficient market hypothesis
suggests that the price of a stock reflects all available information
concerning the future profitability of the firm. Inside information is
not readily available to the public and thus is not reflected in the
stocks price.
Chapter 27: P&A-11 (page: 612)
Find some information on an index fund
(such as the Vanguard Total Stock Market
Index, ticker symbol VTSMX). How has this
fund performed compared with other stock
mutual funds over the past 5 or 10 years?
(Hint: One place to look for data on mutual
funds is http://www.morningstar.com.)
What do you learn from this comparison?
ANSWER:
Answers will vary.
Chapter 29: QfR-1 (page:
660)
What distinguishes money from other assets in
the economy?
ANSWER: (PAGE: 643)
Money is different from other assets in the
economy because it is the most liquid asset
available.
Other assets vary widely in their liquidity.
Chapter 29: QfR-2 (page:
660)
What is commodity money? What is fiat money?
Which kind do we use?
ANSWER: (PAGE: 643-645)
Commodity money is money with intrinsic
value, like gold, which can be used for purposes
other than as a medium of exchange.
Fiat money is money without intrinsic value; it
has no value other than its use as a medium of
exchange.
Our economy today uses fiat money.
c. Because BSB is cutting back on its loans, other banks will find
themselves short of reserves and they may also cut back on their
loans as well.
d. BSB may find it difficult to cut back on its loans immediately,
because it cannot force people to pay off loans. Instead, it can stop
making new loans. But for a time it might find itself with more loans
than it wants. It could try to attract additional deposits to get
Chapter 29: P&A-6
(page:
You take $100 660)
you had kept under your mattress
and deposit it in your bank account. If this $100
stays in the banking system as reserves and if
banks hold reserves equal to 10 percent of
deposits, by how much does the total amount of
deposits in the banking system increase? By how
much does the money supply increase?
ANSWER:
If you take $100 that you held as currency and
put it into the banking system, then the total
amount of deposits in the banking system
increases by $1,000, because a reserve ratio of
10% means the money multiplier is 1/.10 = 10.
Thus, the money supply increases by $900,
because deposits increase by $1,000 but
Chapter 29: P&A-7
The Federal(page: 660)a $10 million
Reserve conducts
open-market purchase of government bonds. If
the required reserve ratio is 10 percent, what is
the largest possible increase in the money
supply that could result? Explain. What is the
smallest possible increase? Explain.
ANSWER:
With a required reserve ratio of 10%, the money
multiplier could be as high as 1/.10 = 10, if
banks hold no excess reserves and people do
not keep some additional currency. So the
maximum increase in the money supply
from a $10 million open-market purchase
is $100 million.
Chapter 29: P&A-8
(page: 660)
Assume that the reserve requirement is 5
percent. All other thing equal, will the money
supply expand more if the Federal Reserve
buys $2000 worth of bonds or if someone
deposits in a bank $2000 that he had been
hiding in his cookie jar? If one creates more,
how much more does it create? Support your
thinking.
ANSWER:
The money supply will expand more if
the Fed buys $2,000 worth of bonds.
Both deposits will lead to monetary
expansion.
Chapter 29: P&A-9
Suppose that the(page:
T-account for First660)
National Bank is as follows:
ANSWER:
a. To expand the money supply, the Fed should buy bonds.