Economics 470/570

Fall 2008

Due: End of class on 10/14

Homework #1

1. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. Suppose there are also 100 different people who want to take out $1,000 loans. Assuming an expected default rate of 10%, use this example to show how pooling risk through financial intermediation can increase the efficiency of financial markets.

2. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. Suppose there are 10 different people who want to take out $10,000 loans. Use this example to show how pooling small deposits through financial intermediation can increase the efficiency of financial markets.

3. Suppose that there are 100 individuals, each with $1,000 in savings that they would like to lend. However, in any given year 10% of them will need the money for emergencies. Because of this possibility, and the dire consequences if they cannot access their money at such a time, they are unwilling to lend the money for long periods of time. Explain how financial intermediation can solve this problem of "borrowing short and lending long" and increase the efficiency of financial markets.

4. Besides pooling risk, pooling small deposits, and pooling over time, what else do financial intermediaries do to increase the efficiency of financial markets?

5. Briefly, what does the phrase “increase the efficiency of financial markets” mean?