Financial Markets and the Economy
Problem Set 5
3. An unanticipated decline in the price level deteriorates firms’ net worth by increasing the burden of their indebtedness, making them less able to lend. This is due to the common practice of long term fixed-rate borrowing; in a deflationary environment, these liabilities increase in real value, while assets remain anchored in nominal value.
4. A decline in real estate prices affects the value of assets used as collateral. Collateralized loans like mortgages, MBS, and CDOs backed by either one also decline in value. The decline in collateral has a proportionate affect on the amount of available credit. The decline also increases financial frictions, dries up liquidity and necessitates deleveraging.
6. After the failure of a major financial institution, short term lending rates increase dramatically due to the expectation that other similar firms may have similar catastrophic problems. In the increased rate e