Chapter 1 Problems and Solutions1.The United States Treasury borrows money on behalf of the federal government allthe time. One type of government borrowing, called a Treasury bill, promises afixed payment at some number of months in the future. The Treasury receives less for a promise to make a payment of $100 in six months than it does for a promise to make a payment of $100 in three months. Why? Explain how this arrangement illustrates the core principle that time has value.Answer: Since time has value, a promise to make a payment of $100 three months from now is worth less than $100 today.2.Describe the links between the five components of the financial system and the fivecore principles of money and banking.Answer:a.Money economizes on the need to obtain information. Sellers don’t need to knowwho buyers are.b.Financial instruments promise payment that may or may not be made in the future.Pricing them uses the first two core principles: time has value and risk requirescompensations.c.Financial markets are where financial instruments are bought and sold. They provideinformation, and they set prices. Core principles #3 and #4 come into play.d.Financial institutions collect and process information. They are based on then factthat information is the basis for decisions.e.Central banks are engaged in stabilizing the economy and averting financial crisis;their behavior is based on the core principle that stability improves welfare.3.Socialists argue that, to reduce the power exerted by the owners of capital, the stateshould control the allocation of resources. Thus, in a socialist system, the stateallocates investment resources. In a market-based capitalist system, financialmarkets do that job. Which approach do you think works better, and why? Relate your answer to the core principle that markets set prices and allocate resources.Answer: Markets allocate use the price system to allocate resources to their most efficient uses. Markets aggregate information from a multitude of sources. Command economies do not aggregate information as well, and do not allocate resources as efficiently.4.Most investment advisers tell their clients to purchase shares in one or more mutualfunds rather than to buy individual stocks. They argue that this practice reduces risk.Explain why.Answer: Holding a large number of investments tends to reduce risk since they are unlikely to all go down (or up) at the same time.5.Small businesses tend to borrow money from banks. Would you lend directly to asmall business? Relate your answer to the third core principle of money andbanking, that information is the basis for decisions.Answer: It would not be very prudent for you to make a loan to a small business. This is true for two reasons. First, you have a difficult time evaluating the borrower’s creditworthiness; and second, it will be very costly for you to monitor what they do with the funds.6.Financial innovation has reduced individuals’ need to carry cash. Explain how. Answer: Everyone has a number of alternative methods of payment. Electronic forms, like credit and debit cards, are the primary ones that have reduced need to carry cash.7.For many years, people got their mortgages at local banks. Today, prospectivehomeowners can get a mortgage through a broker who obtains funds from institutions all over the country. What effect do you think this financial innovation has had on an individual’s ability to obtain a mortgage? What effect do you think it has had on interest rates and mortgage fees?Answer: Mortgages have become more available and cheaper (both in terms of fees and interest rates). Increased competition has been good for borrowers. One of the primary reasons for this is that funds now flow easily between geographic regions. Banks used to be local, taking deposits and making loans in their communities. If the bank had no funds to loan, a potential borrower was out of luck. Innovation has changed all that.8.Suppose central bankers have figured out a way to eliminate recessions. Whatfinancial and economic changes would you expect to see? Relate them to the core principle that stability improves welfare.Answer: If recession were completely eliminated, then everyone’s income would be stabilized and the returns to business investment would become more predictable. This would reduce risk and allow people to do things that they otherwise would not do. One possibility is the economy would grow more quickly.9.What is it important that financial markets offer individuals the ability to buy and sellfinancial instruments quickly and cheaply?Answer: Without the ability to buy and sell stocks, bonds, and other financial instruments no one would want to hold them. Who would buy something they couldn’t sell? So ease and low cost are essential for financial markets to work. And without thosemarkets, no one would issue the financial instruments. The financial system would grind to a halt.10.When you apply for a loan, you must answer a lot of questions. Why? Why is theset of questions you must answer standardized?Answer: The questions are aimed at figuring out how likely you are to repay the loan. They are standardized to reduce the cost of making the loan.11.What factors determine the premiums individuals pay for automobile insurance?Why would differences in those factors affect the amount of the premiums? Relate your answer to the core principle that risk requires compensation.Answer: The premium paid for auto insurance is determined by the likelihood of having an accident and making a claim. The more likely someone is to have an accident, the higher the premium. The higher the risk, the bigger the payment to the company has to be.12.Try to list the financial transactions you have engaged in over the past week. Howmight each one have been carried out 50 years ago?Answer: Commercial purchases that you made likely used credit cards and debit cards.50 years ago they would have all used cash. Payment of utilities (if you do it) might have been done by electronic transfer, rather than a check (which would have been the method 50 years ago).13.Would you expect a college loan to have a higher or lower interest rate than a homemortgage? Why or why not? In your answer be sure to use one of the coreprinciples of money and banking.Answer: To get a home mortgage, a borrower must promise the lender the house if they fail to make the payments. This provides a guarantee to the borrower. Without any guarantee, we expect the loan interest rate to be higher to reflect the added risk. College loans that have no guarantee would likely be much too risky for any lender to make (or they would have such a high interest rate than no student would be able to pay). But if there is a guarantee – the student’s parents or the government guarantees most loans – then the interest rate will fall. If you look, what you will see is interest rates that are roughly equal between mortgages and college loans because the guarantees (and risk) are equivalent.14.Merchants that accept Visa or MasterCard pay the issuer of the card a percentage ofthe transaction. For example, for each $100 charged on Visa cards, a merchantmight receive only $98. Explain both why Visa charges the fee and why themerchant pays it. (You should be able to use at least two core principles in your answer.)Answer: The merchant pays Visa for two things. First they are paid immediately, and time has value. Second, Visa takes the risk that the buyer will not pay, and risk requires compensation.15.The government is heavily involved in the financial system. Explain why. Answer: For markets to work there have to be rules. And the rules need to be enforced. The government both makes the rules and enforces them so that we all trust the markets to work as they should. Without the government to monitor the financial system, ensuring that people behave themselves, the system would collapse.。