Written Assignment 3

Written Assignment 3

1. What is the role of the financial system? Name and describe two markets that are part of the financial system in the U.S. economy. Name and describe two financial intermediaries.

To match one person’s savings to another person’s investment. The Bond Market and the Stock Market. The Bond Market is a way for an institution to borrow directly from the public, by issuing a bond (an IOU). The Stock Market is a way for an institution to raise funds by selling stock, a share of the institution. Banks and Mutual Funds. Banks take in deposits from people who want to save and loan it to people who wish to borrow. Mutual Fund is an institution that sells shares to the public and uses the proceeds to buy stocks, bonds, or stocks and bonds.

2. What is the government budget deficit? How does it affect interest rates, investment, and economic growth?

A government budget deficit arises when the government spends more than it receives in tax revenue. Because a government budget deficit reduces national saving, it raises interest rates, reduces private investment, and thus reduces economic growth.

3. What benefit do people get from the market for insurance? What two problems impede the insurance market from working perfectly?

Purchasing insurance reduces the level of risk they take. Two problems that impede the insurance industry from working correctly are adverse selection and moral hazard. Adverse selection occurs because a high-risk person is more likely to apply for insurance than a low-risk person is. Moral hazard occurs because people have less incentive to be careful about their risky behavior after they purchase insurance.

4. Describe the efficient markets hypothesis and give a piece of evidence consistent with this hypothesis. What does this say about using past price histories to predict future prices?

The efficient markets hypothesis suggests that stock prices reflect all available information. This means that we cannot use...