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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:
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