PE 2 E490 - Answer key to practice exam problems PDF

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Answer key to practice exam problems...

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1. True or false: financial crises have no permanent effects because GDP is typically above its pre-crisis peak within five years. Explain. False; the results of financial crises are robust and lead to large and permanent output loss compared to the counterfactual of trend growth. Witnessing the trends of GDP from recessions and financial crises, it’s evident that there’s a permanent loss from these financial crises. 2. Is there a property of a boom that predicts whether a financial crisis will subsequently occur? If so, what? Does it also predict how deep the recession will be? The role of credit is one of the key mechanisms that helps predict whether a financial crisis will occur. The run-up of credit during the boom is related to the path of GDP after the recession. Higher credit predicts the occurrence of a crisis, and it predicts that the crises will be worse. Bigger amounts of credit lead to larger declines in GDP, suspecting a deeper recession. 3. Does the real exchange rate appreciate or depreciate in a sudden stop? Why? Real exchange rate depreciates. During a sudden stop, the current account increases and capital account decreases. This suggests that foreigners are buying more goods now, increasing production of tradeable goods but decreasing the production of non-tradeable goods. Due to this, the relative price of non-tradeable goods decreases and this causes the RER to depreciate. 4. A common policy pursued by governments when a sudden stop occurs is to devalue the exchange rate. Why would this help? A sudden stop implies a situation in which capital inflows suddenly stop. In such a situation, devaluation improves the country’s trade balance by boosting exports at moments when the trade deficit may become a problem for the economy. This tool aids in shrinking the trade deficit and reducing sovereign debt burdens because a weaker currency makes payments relatively less expensive over time. 5. True, false, or uncertain: When the European Central Bank raises interest rates, the interest rates on sovereign debt in Greece or Portugal increase by more. Explain. Uncertain. When there is a potential for default, interest rates rise. But, interest rates change all the time and the reasons can also be unrelated to default. Depending on the type of sovereign debt (internal or external), the ECB can have an impact. If the debt is external and owed to foreigners, action taken by the ECB will not have a large impact on the interest rates of debt. There is a lot of variation across countries.

6. What is an interest rate spread? What does it measure in the context of sovereign debt? The interest rate spread is r – r*, which is a common measure of the risk of a bond. In terms of equations, r – r* is approximately 1 – P(default*)haircut. This allows one to estimate the implied probability of repayment. 7. Why would a government official declare that a fixed exchange rate would never be broken? A purpose of a fixed exchange rate is to keep a currency’s value within a narrow band. The fixed exchange rate helps the government maintain low inflation, which keeps interest rates low and stimulates trade and investment. 8. What is one mismatch between banks’ assets and liabilities? How can it lead to economic problems? One mismatch is the risk mismatch. Banks tend to have very safe liabilities (deposits) but their assets (like loans) are fairly risky. This creates economic problems because people may default on their loans and this creates risk. Another mismatch is of the maturity of assets. Deposits can be accessed at any time, making them short term. But, assets like mortgage or commercial loans are long term. The bank is unable to demand all the money lent out to homeowners in the form of a mortgage back today, making that risky for the banks. 9. True, false, or uncertain: Economic theory predicts that when house prices go up, people consume more. Explain. What does the data say? True; Housing wealth is the component of the economy that suggests when house prices change, consumer consumption also changes. There is evidence that suggests housing wealth affects consumption, specifically that consumption moves in similar patterns to house prices during boom and recession. Data shows that homeowners increase their consumption when prices go up, the consumption goes up by about 5% of the amount that house prices go up. 10. What is a mortgage-backed security? These are mortgages that become securitized. An investment bank buys a lot of mortgages from banks all over the country, they slice them up, and then sell a small piece of many different mortgages to investors. This diversifies risk because if you buy a mortgage-backed security, you own a small fraction of many different mortgages. Investors in MBS receive periodic payments similar to bond coupon payments.

1. Assuming no banks, if λα + (1-λ)R is bigger than 1, invest completely in the project. In this case, (0.1 x 0.9) + (0.9)2 = 1.89. This means, they should invest directly in the project. By investing completely, their return is R, which is 2. 2. Suppose the bank exists. After all the financiers deposit their money in the bank, what fraction of the money should the bank invest in projects if they expect the good equilibrium? What fraction should it hold behind?...