Chapter 10Credit Markets

Questions1. What is the difference between nominal and real interest rates?

Answer: The nominal interest rate is the interest rate you pay on a loan or receive on a savings account, while the real interest rate is the nominal interest rate adjusted for inflation.

Real interest rate = Nominal interest rate – Inflation rate

Or using symbols, r = i – π, where r is the real interest rate, i is the nominal interest rate, and π stands for the inflation rate.

2. Firms, households, and governments use the credit market for borrowing. The credit demand curve shows the relationship between the quantity of credit demanded and the real interest rate.

a. Why does the credit demand curve slope downward?

b. What can cause a shift in the credit demand curve?

Answer:

a. The downward slope of the credit demand curve implies that the higher the real interest rate, the lower the quantity of credit demanded. This is because the higher the rate of interest a firm or household must pay to borrow money, the lower the firm’s profit. So, fewer borrowers will be willing to obtain a loan at a higher rate of interest.

b. Although a change in the real interest rate will lead to a movement along the credit demand curve, the following factors will lead to a shift of the curve:

● Changes in perceived business opportunities for firms: Businesses borrow to fund their expansions. When more opportunities for expansion are available, the demand for credit at a given real interest rate increases, leading to a rightward shift in the economy-wide, or aggregate, credit demand curve. The opposite—a leftward shift—would occur if perceived business opportunities decreased.

● Changes in households’ borrowing needs: If households grow more optimistic about the future, they’ll be more willing to borrow now because they expect that they’ll be in a good position to pay back those loans later. This will shift the aggregate credit demand curve to the right. Conversely, if households become more pessimistic about the future, the aggregate credit demand curve will shift to the left.

● Changes in government policy: All other things being equal, an increase in government borrowing shifts the credit demand curve to the right, while a decrease in government borrowing will shift it to the left.

3. What factors explain why people save for the future?

Answer: People save for many reasons, some of which are listed below:

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● Retirement: Because the Social Security program pays the typical U.S. household a bit less than half of the household’s pre-retirement income, most people save some of their pre-retirement income to keep consumption levels more or less the same after retirement as before retirement.

● Bequests: Some parents save to leave money for their children. These inter-generational transfers are called bequests. Parents may also save money for their kids’ college education, etc.

● Homes and durable goods: People save to buy a home or to buy durable goods, like a new washing machine or a car.

● Starting a business: In cases where outside funding can’t be obtained, small business owners need to use their own savings to fund their business idea.

● Saving for a rainy day: People save for unexpected events—they may lose their jobs or need money for a medical expense.

4. Households and firms with savings lend money to banks and other financial institutions. The credit supply curve shows the relationship between the quantity of credit supplied and the real interest rate.

a. Why does the credit supply curve slope upward?

b. What can cause a shift in the credit supply curve?

Answer:

a. The credit supply curve is upward sloping because a higher real interest rate encourages more saving, increasing the amount of funds that banks can lend, and thereby increasing the quantity of credit supplied.

b. Although a change in the real interest rate will lead to a movement along the credit supply curve, the following factors will lead to a shift of the curve:

● Changes in the saving motives of households: Households save for many reasons, but these motives change over time, shifting the credit supply curve. For example, if households are generally optimistic about their future income, they may spend more now and save less, shifting the credit supply curve to the left. Conversely, if households decide that they want to increase the amount that they leave to their children, the credit supply curve will shift to the right.

● Changes in the saving motives of firms: When firms distribute part of their earnings back to shareholders through dividends, the credit supply curve shifts to the left because passing earnings back to shareholders can be thought of as dissaving. On the other hand, when firms are at all nervous about their ability to fund their business in the future, they tend to hold on to, or retain, any earnings. In this case, the credit supply curve shifts to the right. This is much the same as when households save for a rainy day.

5. What are the key categories on a bank’s balance sheet? Illustrate using a table.

Answer: A bank’s balance sheet has the following categories of assets and liabilities:

Balance Sheet

Assets Liabilities and Stockholders' Equity

Reserves Demand deposits

Cash equivalents Short-term borrowing

Long-term investments Long-term debt

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Total Liabilities

Stockholders' Equity

Total Assets Total Liabilities + Stockholders' Equity

6. What is the shadow banking system?

Answer: The shadow banking system is made up of financial institutions, such as investment banks, that do not fulfill traditional banking functions: They don’t accept deposits from the public. Nevertheless, they act like banks in the sense that these firms raise money and then make loans with the funds. Lehman Brothers, an investment bank whose bankruptcy fueled the 2008 financial crisis, was one example of a shadow bank. Instead of taking common deposits, Lehman would take loans from large investors, like insurance companies, and use the money to trade stocks, bonds, and derivatives based on those securities. Institutions in the shadow banking system also make loans to businesses and devise new financial products that they can sell to other institutions and wealthy investors.

7. What functions do banks perform as financial intermediaries in the economy?

Answer: Banks perform three interrelated functions as financial intermediaries:

● Banks identify profitable investment opportunities by bringing together credit-worthy borrowers and depositors and channeling depositors’ savings to borrowers.

● Banks transform short-term liabilities, like deposits, into long-term investments in a process called maturity transformation. Maturity transformation allows the economy to undertake significant long-term investments.

● Banks transfer risk from depositors to the bank’s stockholders and, in severe financial crises, to the U.S. government.

8. What is maturity transformation?

Answer: The process by which banks take short-term liabilities, such as demand deposits, and use them to invest in long-term assets, like loans, is called maturity transformation. Demand deposits have a 0-year maturity because the depositor can take back his or her money at any time. In contrast, when banks lend to borrowers, such loans usually have a maturity of 5–30 years.

9. What is stockholders’ equity? Who bears the risk that a bank faces when stockholders’ equity is greater than zero?

Answer: Stockholders’ equity is defined as the difference between a bank’s total assets and total liabilities. Stockholders are the primary risk takers, but it should be noted that if their equity is wiped out, any losses cascade down to either lenders or the government. Hence, undercapitalized banks, that is, banks whose stockholder equity is a very small proportion of assets, run a significant risk that a decline in asset values could not only wipe out stockholders, but also impact others.

10. What is a bank run?

Answer: A bank run is a situation where a large proportion of a bank’s depositors try to withdraw their money at the same time. If the bank has mostly long-term, illiquid assets, it may not be able to pay out all the withdrawals. As word gets out that the bank’s cash is running low, more depositors will try to make withdrawals in the hope that they can get what little cash remains.

11. What is deposit insurance? Is deposit insurance successful in preventing bank runs?

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Answer: Deposit insurance is offered by the government and protects depositors’ balances up to a certain amount. All deposits at or below the cap are paid out in full by the government in the event that a bank cannot meet its obligations.

In the United States, bank runs have been relatively rare since the 1930s because of the deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC). However, institutional bank runs—where large lenders fear default by their borrowers—did occur during the financial crisis of 2007–2009. Unlike households, institutions make deposits and short-term loans that are far too large to be insured fully by the FDIC.

12. As the Choice and Consequence box on “Too Big to Fail” notes, bank regulators worry about the prospect of the failure of large institutions, dubbed “systemically important financial institutions” (SIFIs).

a. How would the failure of a SIFI affect the economy?

b. What steps do bank regulators take to prevent SIFIs from failing or to minimize the effect of such failures?

Answer:

a. A SIFI’s failure could have repercussions for the entire banking sector and the economy as a whole. All of the banks to which the failed bank owes money will suffer losses. In turn, these losses can cause runs on the banks involved or wipe out the capital (stockholders’ equity) of these banks, leading to bankruptcy. As one bank after another fails, the ripple effects of financial losses keep spreading through more and more banks. In theory, the failure of one SIFI could bring down the whole financial system.

b. To protect the economy from the effects of the failure of a SIFI, bank regulators have adopted two strategies. First, they now require large banks to set up “living wills” that spell out how the bank would sell its assets and pay off its creditors in the event that it needed to end its business operations. Such living wills are designed to make it more credible and easier for a government to shut down a failing bank, including a failing mega-bank. Second, regulators are now requiring banks to take on less risk and hold more stockholders’ equity, reducing the likelihood that a large bank will get into trouble in the first place.

13. Banks fail when they invest in long-term assets that subsequently fall in price. What are the two views on why asset prices fluctuate so much that they lead to financial crises and bank failures?

Answer: The theory of efficient markets asserts that asset prices are based exclusively on fundamentals. This theory implies that all movements in asset prices reflect a rational appraisal of new information, not a tendency for investors to let their emotions get in the way. In this view, fluctuations in asset prices are interpreted as episodes in which important new information becomes available to investors. An alternative view links asset price fluctuations to bubbles in asset prices, which occur when asset prices depart from fundamentals. In this view, substantial asset price bubbles can arise, partly driven by psychological factors and biases, particularly during specific episodes such as extended economic and stock market booms.

Problems1. Optimizing economic agents use the real interest rate when thinking about the economic costs and

returns of a loan.

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a. Recently, the average rate paid by banks on savings accounts was 0.45%. However, at the same time, inflation was around 1.5%. What was the average saver’s real rate of interest on his or her savings?

b. Banks expect that the rate of inflation in the coming year will be 3%. They want a real return of 5%. What nominal rate should they charge borrowers? Explain, using the Fisher equation.

Answer:

a. Recall that the real rate of interest is defined as:

where r is the real interest rate, i is the nominal interest rate, and π is the rate of inflation. Substituting the values in the problem, i = 0.45%, π = 1.5%, which implies that r = 0.45% – 1.5% = –1.05%. So, the average saver is losing 1.05 percent in buying power every year.

b. In this question, r = 5%, and πe = 3%, where πe stands for the expected inflation rate. Rearranging the equation for the real interest rate, this implies that banks should set the nominal rate they charge on loans at:

2. The 1970s was a period of high inflation in many industrialized countries, including the United States.

a. Due to the increase in the rate of inflation, lenders, including credit card companies, revised their nominal interest rates upward. How is the rate of inflation related to the nominal interest rate that credit card companies charge? Why would lenders need to increase the nominal interest rate when the inflation rate increases?

b. Usury laws place an upper limit on the nominal rate of interest that lenders can charge on their loans. In the 1970s, in order to avoid usury laws, some credit card companies moved to states where there were no ceilings on interest rates. Why would credit card companies move to states without usury laws during a period of high inflation like the 1970s?

Answer:

a. It is the real rate of interest that matters to lenders and borrowers. The real interest rate is calculated by subtracting the inflation rate from the nominal interest rate. When the rate of inflation increases, the nominal interest rate needs to increase to keep the real interest rate constant.

b. Usury laws do not constrain lenders when the inflation rate is low because a reasonable real interest rate does not require a high nominal interest rate in a low-inflation environment. However, as the inflation rate rises, it is necessary to increase the nominal interest rate one-for-one to maintain the real interest rate. In such a situation, an upper limit on the nominal interest rate could constrain a lender.

Adapted from an article by the Federal Reserve Bank of Chicago found here: http://www.math.utah.edu/~zobitz/pdf_files/Fall04_teaching/interest_rate.pdf

3. In August 1979, the annual rate of inflation in the United States was nearly 12%, and the U.S. short-term nominal interest rate was nearly 10%. Over the next 35 years, both the rate of inflation and short-term nominal interest rate tended to fall. By August 2014, the rate of inflation was about 2%

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and the short-term nominal interest rate was close to 0%. How has the real short-term interest rate changed from 1979 to 2014? Why do the inflation rate and the nominal interest rate tend to move together over the long run?

Answer: Recall that the relationship between the real interest rate, the nominal interest rate, and the rate of inflation is given by:

where r = the real interest rate, i = the nominal interest rate, and π = the rate of inflation.

Substituting in the August,1979 values from the problem, r = 10% – 12% = –2%. For August 2014, the calculation is r = 0% – 2% = –2%, the same as in 1979.

Hence, as of August 2014 the real short-term interest rate is unchanged from its value in August 1979. The nominal inflation rate fell as the inflation rate fell, which kept the real rate constant.

The equilibrium real rate of interest is ultimately determined by the intersection of the credit demand and supply curves in the credit market. The real rate changes only if either of those curves (or both) shift, as detailed in the chapter. If we rearrange the above equation to read

it can be seen that, given r as determined by equilibrium in the credit market, an increase in π results in an equal increase in i such that r stays constant.

4. Many kinds of loans, like student loans and mortgages, can be taken out at either a fixed or variable rate. A fixed rate loan allows the borrower to pay the same nominal interest rate for the entire lifetime of the loan, while a variable rate loan may experience changes in in the nominal interest rate as the rate that banks charge each other for overnight loans changes. For this problem, assume that this variable nominal interest rate adjusts such that the associated real interest rate remains constant over time.

a. In the first year, inflation is 2.75 percent and the nominal interest rate for both the fixed and variable rate loans is 5 percent. What is the real interest rate for the fixed rate loan? What about for the variable rate loan?

b. In the second year, inflation rises to 3 percent. Calculate the nominal and real interest rates for the fixed rate and the variable rate loans described in part a.

c. What happens if the inflation rate falls? Could a borrower end up facing a much higher real interest rate with a variable rate loan? With a fixed rate loan?

d. Suppose you are deciding between a fixed rate and a variable rate loan and that you dislike risk (variability) in the real interest rate you pay. Should you opt for a fixed rate or a variable rate loan? Are there any reasons for a borrower to dislike variability in the nominal interest rate rather than the real interest rate she faces?

Answer:

a. The real interest rate for the fixed rate loan is given by

where r = the real interest rate, i = the nominal interest rate, and π = the rate of inflation. Plugging in, then, we get that the real interest rate for both the fixed and variable rate loans is 2.25 percent.

b. Again, we use the equation from above. The fixed rate loan is simple—the nominal rate is still 5 percent, so the real interest rate is 2 percent. For the variable rate loan, the nominal rate should

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adjust so that the real interest rate remains at 2.25 percent. Rearranging the equation above, we get that the nominal rate for the variable rate loan should be at 5.25 percent.

c. The real interest rate could, indeed, go up with a fixed rate loan (particularly with deflation, when inflation would be negative and the real interest rate would be higher than the nominal interest rate). With a variable interest rate, however, the real interest rate will always remain the same.

d. If you dislike variability in the real interest rate, then you’re better off choosing the variable rate loan, because it will adjust to keep the real interest rate constant. It’s possible, though, that you want to keep the nominal interest rate constant, perhaps because you get paid in nominal dollars and like the predictability of paying a certain percentage of your wage each month.

5. Explain how the equilibrium real interest rate and the equilibrium quantity of credit would change in each of the following scenarios, and illustrate your answer with a well-labeled graph of the credit market.

a. As the real estate market recovers from the 2007 – 2009 financial crisis, households begin to buy more houses and condominiums, and apply for more mortgages to enable those purchases.

b. Congress agrees to a reduction in the federal deficit, which results in a significant decrease in the amount of government borrowing.

c. Households begin to fear that the recovery from the 2007-2009 recession will not last, and become more pessimistic about the economy.

d. Businesses become more optimistic about the future of the economy, and decide to distribute more of their earnings as dividends to their shareholders.

Answer:

a. As households apply for more mortgages to purchase real estate, the demand for credit increases, and the credit demand curve shifts to the right. This increases the equilibrium real interest rate as well as the quantity of credit, as shown in the graph below.

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b. As government borrowing decreases, there is a consequent decrease in the demand for credit. The credit demand curve shifts to the left, lowering the equilibrium interest rate and the equilibrium quantity of credit. This is illustrated in the graph below.

c. The increase in household pessimism would result in a decline in borrowing by households, reflected in a leftward shift in the credit demand curve. By itself, this would lower the equilibrium real interest rate and the equilibrium quantity of credit.

However, households would also tend to increase their saving, thus shifting the credit supply curve to the right. This action further lowers the real interest rate but increases the quantity of credit.

Hence, the combination of a decrease in credit demand and an increase in credit supply would definitely lower the equilibrium real interest rate but have an ambiguous effect on the quantity of credit. (Note: The graph below shows a small decrease in the equilibrium quantity of credit because the credit demand curve shifted to the left by a greater horizontal distance than the credit supply curve shifted to the right.)

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d. If the business community becomes more optimistic about the economy, they will tend to increase their borrowing to fund investment and expansion. This will shift the credit demand curve to the right. At the same time, distributing more of their earnings to shareholders as dividends will decrease the supply of credit (assuming that the shareholders spend those dividends), shifting the credit supply curve to the left.

The net result of these two effects is shown in the graph below. The equilibrium real interest rate will definitely increase, but the effect on the equilibrium quantity of credit is ambiguous, and depends on which curve shifts by the greater horizontal distance. (Note: The graph below shows a situation where the leftward shift in the credit supply curve is exactly offset by the rightward shift in credit demand, resulting in no change in the equilibrium quantity of credit.)

6. Households, like banks, maintain balance sheets. Although these assets and liabilities may not be written down in a neat table, they still influence household decision-making.

a. We saw in this chapter that for banks, assets are equal to liabilities. Do you expect the same to be true for a household? Explain.

b. What kinds of assets might the average household have? Of these, which do you think are the most liquid?

c. How would a one-time loan made to a relative affect a household’s annual balance sheet? What about purchasing a car with cash?

d. During the financial crisis of 2007–2008, the federal government decided to bail out the big banks, but not any of the households that had lost money because of their investments or house purchases. What kinds of justifications might there be for this type of federal government policy?

Answer:

a. Not necessarily. In fact, we saw that shareholder’s equity makes up the difference between assets and liabilities for the bank—households, of course, don’t have shareholder’s equity. Indeed, many American households do face large debts (e.g. credit card debt) and likely have liabilities greater than assets. Other households—young home renters, for example—may have assets greater than liabilities.

b. Households can have cash, investments (e.g. equities, bonds, retirement accounts), physical investments like cars or jewelry, or houses. Cash and checking accounts are the easiest to use quickly, which makes them the most liquid.

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c. A one time loan would decrease available cash on the lender’s asset side, and replace it with a loan on the asset side (representing the expectation of future payment). This loan, of course, is much less liquid than the cash. Purchasing a car with cash would have a similar effect; a decrease in cash on the asset side, replaced with the long-term physical asset of the car.

d. In the chapter, we discussed the importance of systemic risk in justifying government intervention. Households, while perhaps interconnected to some degree, have much smaller, simpler balance sheets than banks—thus, you could argue that the impact of a government intervention would be smaller, with minimal impact. In addition, the government imposes restrictions on banks—it would be much harder to monitor the finances of individuals.

7. Banks that practice narrow banking match the maturity of their investments with the term of the deposits that they collect from the public. In other words, narrow banks take short-maturity deposits and invest in assets that carry a low level of risk and are also of short-term maturity, like short-term government debt.

a. Suppose that all FDIC-insured banks decide to adopt narrow banking. How would narrow banking reduce the level of risk in the banking system?

b. If narrow banking reduces systemic risk, why do banks still practice maturity transformation?

Answer:

a. Narrow banking would reduce the level of risk in the banking system by reducing the likelihood of bank runs and liquidity problems for banks. Narrow banks match the maturity of their deposits with that of their investments. Because depositors’ money is in the form of short-term, liquid investments, banks will be able to convert these investments into cash easily and return money to their depositors when they ask for it.

b. Banks take short-term deposits from savers and make long-term loans to investors. This crucial function allows the economy to undertake significant long-term investments. Maturity transformation allows banks to match savers with investors.

8. If you have studied microeconomics, you may recall a concept called “moral hazard.” Moral hazard occurs when an economic agent is incentivized to take risks because some (or all) of the losses that might result will be borne by other economic agents.

Discuss how federal deposit insurance, administered by the FDIC as described in the chapter, might lead to moral hazard.

Answer: Moral hazard occurs whenever a policy changes incentives, which in turn changes behavior. Because of federal deposit insurance, the majority of depositors need not pay any attention to the lending practices of their bank. Depositors are more likely to decide where to bank based on the interest rate offered, or on convenience. Consequently, a bank’s customers won’t worry about whether a bank is badly run, nor will they worry about whether a bank is making unprofitable long-term investments. The depositors will get their deposits back in any case because of deposit insurance.

Likewise, knowing that their depositors’ funds are covered gives banks’ management more incentive to acquire riskier assets, e.g., to make riskier loans than they otherwise would. If the assets perform well, the bank will earn higher profits. If the assets decline in value, and lead to losses, the bank’s depositors are still covered.

9. Recall from the chapter that banks in the United States hold a fraction of their checking deposits as reserves, either as vault cash or as deposits with the Federal Reserve (where they earn very little interest). Regulations require them to hold a certain percentage (currently 10 percent) of their

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checking deposits as reserves. However, banks are free to hold additional reserves if they choose. The latter are called excess reserves. Ordinarily, banks held very few excess reserves. However, starting in the financial crisis of 2007 –2009, the amount of excess reserves held by banks went from virtually zero to over 1.8 trillion dollars.

a. Explain why banks would be expected to try to minimize the amount of excess reserves that they hold.

b. Based on what you learned about banking in the chapter, explain why you think that the crisis prompted banks to dramatically expand the amount of excess reserves they held.

Answer:

Note: This question anticipates material to come in the next chapter on the monetary system.

a. Ordinarily, banks would seek to keep their level of excess reserves as low as possible—often at zero. Indeed, this is exactly what we have seen during and after the financial crisis of 2007–2008.

Recall that reserves are held in the form of vault cash, or as deposits at the Federal Reserve. Cash earns no return, and up to October of 2008, deposits at the Fed earned no interest either. Even when the Fed began to pay interest on banks’ reserve deposits, the rate paid was well below the rate that banks could make on loans or on most other assets. So, holding more reserves than required would involve a significant opportunity cost for banks: They are giving up the higher returns they could earn if they used their excess reserves to make new loans.

b. Perhaps the most important factor that prompted banks to increase their excess reserves so dramatically was the uncertain and chaotic financial environment during the crisis. As many residential mortgages, and other financial instruments related to those mortgages, began to decline in value or even default, banks faced a significant fall in the value of the assets on their balance sheets. Recall that a decline in the value of assets, when not offset by any concurrent decline in liabilities, means that bank capital, or shareholders’ equity, also declines. And if shareholders’ equity approaches zero, or even becomes negative, the bank is considered insolvent. Hence, banks sought to create a “buffer” to compensate for the decline in the value of key assets on their balance sheets. And the fastest, most certain way to do that was to drastically curtail lending. As old loans were paid off, no new loans were made to replace them. On top of that, banks were nervous about the creditworthiness of potential borrowers, even other banks. This provided yet another brake on lending. Moreover, the demand for credit dried up. Businesses, as well as families who would ordinarily be in the market for mortgages in order to buy a home, were wary of taking on more debt, and hence the demand for loans declined.

So, all of these factors meant that any funds that came into the bank were retained as reserves, which led to the dramatic increase in excess reserves that we have witnessed since 2007–2008.

10. In this problem, consider a simple mutual fund. Households and businesses invest in the fund by buying shares; the fund uses this money, in turn, to invest in a range of assets, including equities and bonds. If an investor wishes to divest from the fund, she can “redeem” her shares. Redeeming involves selling the shares back to the mutual fund for a price called the “net asset value” (NAV). The NAV is equal to the difference between assets and liabilities, divided by the total number of investors in the fund (similar to the shareholders’ equity discussed in this chapter). The NAV is updated at the end of each day. Thus every investor who redeems on a given day will get the same price.

a. What does this fund’s balance sheet look like?

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b. Suppose several large investors in the mutual fund start getting nervous about market conditions and decide to redeem, all on the same day. How will these redemptions affect the fund’s balance sheet?

c. Suppose now that investors anticipate that other (large) investors will redeem. How will this affect their incentives to redeem? Link your answers to the notion of bank runs discussed in this chapter.

d. Assume that the economy has 15 other, identical mutual funds. As the fund in part b begins selling assets to pay back investors, the market price of those assets drops. How would this price drop affect the balance sheets of the other mutual funds that invest in those assets? Does this also relate to bank runs? Clarify the differences between your answers to this part and part c.

Answer:

a. On the liabilities side, we have the money given by the individual investors—they can redeem at any point, so it becomes a liability. On the assets side, we have all of investments that the manager has chosen; the difference between the two sides is the NAV. (It’s also acceptable if students put different, more traditional liabilities, and say that the NAV is the only place where the investors in the fund enter in—which is closer to how mutual funds actually work).

b. Now, the fund will have to get the money to pay its investors. Thus, it will need to sell some of the assets side; it may have some cash on hand to pay investors, but, if enough people redeem, it will need to sell off more.

c. As the problem describes, anyone who redeems on a given day will get the Net Asset Value from the night before. However, as we saw in part b, redemptions will actually pull down the NAV because of reductions in the assets; at the end of a day with many redemptions, the NAV will be lower than the day before. An investor, then, who expects a large number of redemptions in a day, will also want to redeem on that day, particularly if she thinks that the redemptions are occurring because of negative sentiment about the fund. As we saw in the chapter with bank runs, individuals can seek to take their money away if they believe that everyone else is—and if they think their investments might not be safe tomorrow.

d. Now, we’ll see the value of the assets of those other mutual funds go down—leading to a decrease in their NAVs. This effect, itself, does not relate to bank runs—this is more of an example of systemic risk, in that an event at one institution has impacts that reverberate throughout the system. In part c, sentiment played a primary role in pushing investors to redeem, leading to a downward spiral. Here, while the systemic decrease in NAV could generate negative sentiment, the primary phenomenon of interest is the systemic impact of a price decrease on the assets of similar financial institutions.

11.

12. The sharpest one-day percentage decline in the Dow Jones Industrial Average (DJIA) took place on October 19, 1987. The DJIA fell 23% on this one day. Foreign exchange markets and other asset markets also exhibit large fluctuations on a daily basis. Based on the information given in this chapter, discuss some factors that could explain why asset prices fluctuate.

Answer: According to theory of efficient markets, asset prices are based exclusively on fundamentals. In this view, any fluctuation in a stock price is attributed to a rational appraisal of new information about the profitability of the company, not a tendency for investors to let their emotions get in the way. On the other hand, another view has been gaining traction in recent decades. Asset bubbles occur when asset prices

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deviate from their fundamental value. This can occur due to a herd effect, limited investor rationality, or other psychological factors or biases. Bubbles are also likely to be followed by a market crash. This can be another source of fluctuations in asset prices.

Based on: http://www.phil.frb.org/research-and-data/publications/business-review/1996/january-february/when-the-bubble-bursts.cfm

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