Whitman College Econ 407 Exam 2 November 7, 1997 1. (a) (5pts) Define adverse selection, and provide an example. (b) (5pts) Define moral hazard, and provide an example. (c) (15pts) Consider the state-run insurance schemes for bank liabilities (bank notes and/or bank deposits) that were in effect at some time during the period 1829-1923. With reference to the problems of adverse selection and moral hazard, briefly describe the elements that made for a successful (versus an unsuccessful) state-run bank liability insurance scheme. 2. (20pts) Briefly sketch an argument for more Federal Reserve independence. 3. Consider the following model. The banking industry holds one kind of deposit, a transactions deposit. The money supply is defined to be currency in the hands of the public (C) plus deposits (D). The monetary base is currency in the hands of the public plus reserves (R) in the banking industry. Assume that the public holds some currency and that banks hold some excess reserves (ER). Let r be the required reserve ratio on deposits. (a) (5pts) Define and derive the money multiplier. Suppose the currency to deposit ratio is 0.2, the excess reserves to deposit ratio is 0.05, and the required reserve ratio is 0.11. (b) (5pts) Solve for the money multiplier. (c) (5pts) Describe an open market operation that would cause the money supply to ultimately rise by 10 million dollars. (d) (5pts) Describe an open market operation that would cause the money supply to ultimately fall by 20 million dollars. (e) (5pts) If the Fed were to sell 2 million dollars of government Treasury bills, what would ultimately happen to the money supply? (f) (5pts) When a bank repays the Fed 5 million dollars for a discount window loan that has come due, what happens to the money supply?(g) (5pts) Describe what would happen to the money supply if the Fed lowered the required reserve ratio to 0.10. 4. (20pts) With reference to a graph of the interest rate versus quantity of loans in the Federal Funds market, describe what happens to the Federal Funds Rate when the Fed makes an open market sale of US Treasury