Economics 181 Homework #5 Answers 1. a. Investors dislike risk and thus risk aversion is the idea that investors select assets to hold in their portfolio based upon the risk of each asset’s return. A risk adverse individual will consider holding risky assets only if they provide compensation for the extra risk involved. Portfolio diversification is the idea that a portfolio which holds diversified assets actually maintains less risk then if all the asset was held individually. This is because in a diversified portfolio, one asset’s risk is partially nullify by the other assets held. b. The better diversified portfolio, which we expect to hold less risk is the one that contains stock in both the car manufacturing company and the shoe company. This is because for the other portfolio, a good year for the car manufacture is likely to mean a good year for the tire company. Hence, the two stock are likely to be highly correlated with each other, and therefore the return from this portfolio would be more volatile that the returns from the diversified portfolio. 2. a. In comparison to other financial institutions, banks have stricter reporting and are more highly regulated. Nonbanking financial institutions have their role increased by securitization over which regulators do less monitoring and have less control. Now, as the role of nonbank financial institutions increases with securitization, the percentage of the financial market that bank regulators have control over decreases. As a result, the ability of the regulators to keep track of risks to the financial system also declines. b. Most believe that the largely unregulated nature of global banking activity leaves the world financial system vulnerable to a massive scale bank failure, which would be devastating to the world economy. 3. The amount of seigniorage governments accumulate does not grow monotonically with the rate of monetary expansion. The real revenue from seigniorage equals the money growth rate times the real balances held by the public. A greater monetary growth leads to a greater expected future inflation rate and then to a greater nominal interest rate. This reduces the real balances people are willing to hold, and it leads to a fall in real seigniorage. With long run equilibrium, in which the nominal interest equals a constant real interest rate plus the monetary growth rate, a rise in the monetary growth rate raises real seigniorage revenues only if the elasticity of real money demand with respect to the expected inflation rate is greater than –1. This is due to the fact that economists feel that at very high inflation rates this elasticity becomes very negative. 4. a. By making the economy more open to trade, liberalization is likely to increase a developing country’s chances to qualify for borrowing funds from abroad. In effect, the penalty for the developing country’s default is greater. b. As a result of a new open market, exports would be expected to increase. Higher export levels would work to reassure prospective lenders about the country’s ability to repay its debts in the future. Furthermore, through open market policies, a developing country reduces lender’s assessment of the country’s risk level and in return, increase investor’s assessment of their credit-worthiness. Review Questions: 1. 2.