Economics 116, spring 2022: Problem Set 10

Out Friday Apr. 19, ot 6:00pm EDT. Submit on Grodtscopt . P/tost tithtr print this question shttt
onswtr on it, thtn Hon; or writt answers directly on tht pd/. Tht format of your onJwtr m..lil1 match
tht question pogts, btcoust Grodtscopt hos a scan of this ttmplott and txptcrs to find your onswtr
in tht somt place on tht pogt. Don't writt your nomt onywhtrt: that mokts gradi ng anonymous .

J. Trn,c,rf.,ls<?( l2points)
Furr..di of 1h, sl<1tnnr11ts bdau,,fil/ in 1hr appropri.,lr cirdt 10 indUatr whcthrr it is rr-w cn-Jb. Thrn, bri,JIJ rxplain in"
roupk ,if «mmra. (3 poirrts j,K t,1d1. I far 1/11 "nsuvr,md lfar.i NITl'rtjrmifir,uion.)
1. 1. Suppos,, 1ha1 Max h:as a lowrr discount rate than Hrr,.,.·. TMn Max wonld hr willing m pay mon, for a risky siock
than Henry would .
Thisstatcnu.·nt i~ (choose on.:): • True OF~
1.2.Erpla1111tio11:
According to the Gordon Formula, price= dividend over next year/ (discount rate -
growth dividends). If discount rate is lower, the denominator is smaller, mea ning
the price is larger. This is why Max is willing to pay more. More generally, a low
discount rate equates to a higher future cash flow value.

1.3. Credit ~ores such u the FICO Ko re (sec http, .f/w"'"'' ·"cr,fo.1!lct.<:on1/art,ck/ financc/ fi.o·KOH or
hnp,;:j/.-n .wikiprJi.1.ori;J,nkijCn,di1_,- .orc for background information) arc chidly usc,ful IO banks in combating
monlh.uardprobk·ms.
Thisnatcmcntis(choosronc): 0Trur . F.i.lsc

1.4.ExpJ,matkm·

A moral hazard problem is what the borrower does after the lender lends to the
borrower. Credit scores are better at combating adverse selection problems as
they can tell banks about the borrower before the lender (the bank) lends the
borrower anything.

1.5. Even in a world .,.,;thou! deposit ins uran,e, a well mJn~grd bank should nr.>trcxpcricntt a bank run. bc,ausc ii
will on ly make loan, 10 creditworthy borrowcTJ and ,o will nr.·cr loK money.
Thisstat~m.-mis(choosronr): 0Trur • False
1.6. Exp1..na1wn,
Bank runs can still occur even if banks only loan to creditworthy borrowers because
banks have a maturity mismatch. Banks hold long assets (loans), which are difficult
to call back, and short liabilities (deposits), which can be withdrawn quickly. If a
large number of depositors suddenly wish to withdraw their deposits, banks cannot
call back their loans quick enough to appease the depositors, leading to a liquidity
crisis, and hence, bank runs.

1. 7. Evrn ma world withou t depom 1nsurance, b.nk runs could be: enarel) ~ntcd 1f1he Federal Rncn-e wu
willing fo act as a lender of last re;nn whcne~r any hank fared an ill iquidi1y probkm.
ThissU.tffllCn t is (choose one:): 0 True • Fabe

1.8 . Expl.,,...,;,m:
The Fed acting as a lender of last resort is a temporary solution to a liquidity
problem, but it cannot keep up wit h insolvencies (defaults on bank loans due to
falling asset prices) and the consequential informational cascad es that can lead
exponent ially more banks t o fail. Therefore, the Fed needs to bail banks out inst ead
of just acting as a lender of last resort.

2. Effeim1tm1rkm(l0pnmts)
In l«ture 2 1, Prof. Tsyvinski described the 20 13 awaniof rhe Nobel ,\1cmorial Prize in Economic Scimasto
Fama, Hansen, and Shiller insolll(Wftat p;arado~cal•sounding fmns u "(f)heonly lime (!he) Nobc:l wugi>-cn for
two theories directly con tradicting each niher.· Hopefu ll y that piqued )VUr imcmt a link. This question gives you
the excuse 10 read a link more. To answa 1hc quatioru< bc:low, use the informarion provided by thr Nobel
C.ommim:c af hn ps://www.nnl>dpriu.o,Ypri z,: i/nonomic-~<ien«-J/ 2013/ prr,.,,·rdca'f/ , including the link to
the information for the public al hnp•://,,...,,..,,.. ,.,,b,,lpri7.c.nri;/up!~•/2018/ 06/ popular-
«t!llOmio<cicncc•2013.p<lf, and, if you like, any other information avail.abk linb:d from du.1 ~e.
2. J. F;un.a. (and ro JOme enent Hansen) wu a~rdcd 1he Nobe,! for arguing (.,.;it, nickn«) ~t m>ekpri«s an,
un prcdicubk. Ixscribc: in what precise sc~ Fama argued that .ind< priers an, unp«dict:ible, and what eviden«
hep~.{4p,:>ims)
 Fama states that "stock prices are extremely difficult to predict in the short run"
because "new information is very quickly incorporated into prices." Information
which cannot reach the general public before it affects prices.

2.2. Shilltt was awardc:d the Nobel for argumg (with CV1dcn«) that stock pncn ;an: pml.inabk. Describe m \\iut
prttiKKnKShilluargucdt ha1s1ockpricrsarr prnlictablr.andwh.ite-vidc:nahc-gavr. (4roinuJ

Shiller argued that stocks prices are predictable in the longer run in the sense that
"the ratio of prices to dividends tends to fall when it is high, and to increase when it is
low." According to his research, a high ratio one year tends "to be followed by a fall in
prices relative to dividends over subsequent years, and vice versa" .

2.3. AllFam.aandShlller's throrirsin faci comradkmrv, orcan thc-v bo!:hbe ri h1 ? Ex bin. (2 ,.,;.,u)
They can both be right. Fama is talking about short-term stock price fluctuations,
whereas Shiller is talking about long-term trends. They do not contradict each other,
rather, they both serve to give us a better view of how stock prices change over time.