Economics 11

Spring 2005

Due Wednesday April 6           Homework 8

 

 

Ch 14

 

Problem 2, 4, 5

2.  If the interest rate is 11%, then the present value of $15 million to be received in four years is 15/(1.11)4 = $9.88 million.  Since the project costs $10, it is not worth it. 

At 10%, the project is worth 10.25 million, so the present value of the payoff is greater than the cost.

At 9%, the present value is $10.63 million and at 8% it is $11.03 million.

 

b.  The exact cutoff for the interest rate between profitability and nonprofitability is the interest rate that will equate the present value of receiving $15 million in four years with the current cost of the project ($10 million):

          $10 =15/(1 + x)4

          10(1 + x)4 = 15

          (1 + x)4 = 1.5

          1 + x = (1.5)0.25

          1 + x = 1.1067

          x = 0.1067

    

4.  You would be better off with stocks in different industries since you only have 10 stocks.  That would provide a more diversified portfolio.  Similarly, you would do better to have stocks that are in different nations.

 

5.  A stock that is very sensitive to economic conditions such as an automaker will have a higher average return than a stock that is relatively insensitive.  The company that is sensitive to economic conditions will have a much higher variability of returns.  To get stockholders to buy the stock with the higher variability of returns, it would have to pay a higher average return.   

 

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Ch 16

 

Problems  4, 6, 7, 9 

 

4.a.  If someone on Yap discovered an easier way to make limestone wheels, stone wheels would not be as scarce and therefore not as useful to use for money.  There would be too much money around and its value would fall.  People might stop accepting them if there was too much of it.

b.  If counterfeit $100 bills were easily made, people would be reluctant to accept $100 bills.  That would force people to use $50 bills or smaller bills and it could entail some cost, since $100 bills make life easier for some people.

 

6. 

Tenth National Bank

 

Uncle

 

Assets

Liabilities

 

Assets

Liabilities

-$100 loan

-$100 check

 

-$100 Check

-$100 Loan

 

The bank’s assets and liabilities both fall by $100.  The uncle’s assets fall by $100 when he writes out the check, but his liabilities (his loan) also falls when he pays it off.   His wealth does not change, since his assets and liabilities both fall by $100.

 

7. 

 

 

 

 

 

 

 

 

 

 

 

 

a.  

BSB

 

 

 

 

 

 

 

 

 

 

 

Assets

Liabilities

 

 

 

 

 

 

 

 

 

 

$25 Reserves

$250 deposits

 

 

 

 

 

 

 

 

 

 

$225 Loans

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

b. 

BSB

 

 

 

 

 

 

 

 

 

 

 

Assets

Liabilities

 

 

 

 

 

 

 

 

 

 

$24 Reserves

$240 deposits

 

 

 

 

 

 

 

 

 

 

$216 Loans

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

c. 

Other banks will have to reduce their loans as well and the money supply will shrink.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

d. 

It will be hard for BSB to cut back on its loans immediately, since it can't force people to pay them off.  It can stop making new loans.

 

 

It could try to attract new deposits to get more reserves or borrow them from the Fed or from another bank.

 

 

 

 

 

9.  A $10 million open market purchase with a reserve ratio of 10% means a maximum of $10/.10 = $100 million increase in the money supply.  The smallest possible increase is $10 million if no new loans are created. 

 

 

Go to the St. Louis Federal Reserve site called FRED II at http://research.stlouisfed.org/fred2/

Click on Monetary Aggregates

Click on Demand Deposits at Commercial Banks (There are several choices.  Use the seasonally adjusted (SA) and the weekly (W) series)

On your homework answer sheet, print out the graph that you see  (Right click in the graph, hit Copy, then Paste it into your homework)

Now answer this question:    There a big spike in the graph.  When did the demand deposit component of M1 jump (you can download the data to help you answer this question)?  Why do you think that happened?

 

The spike occurred during the week of September 11.  How could there have been such a big increase and why?  People and institutions panicked and the Fed wanted to prevent any bank runs.  So what did it do?  It flooded the market with money, buying bonds from anyone who wanted to sell them.  The people doing the selling took the money the Fed gave them and deposited them into their checking accounts.  As a result, the amount of demand deposits rose by $150 billion—a nearly 50% increase in that part of the money supply literally in days.