ECON 162B A0 A1 Fall 2011 Kenny Christianson due September 23 ANSWER KEY PROBLEM SET NUMBER THREE 1 a A brief chronology of the credit crisis of 2008 2007 Financial markets begin to unravel as home foreclosures top 1 million per year in the United States The Fed responds by opening up Term Auction Facilities as an alternative to the discount window to provide loans to banks In the Term Auction Facility the Fed announces a certain quantity of funds to be auctioned off and then the interest rate charged is determined by the bids received 2008 2009 The financial crisis of 2008 begins as the investment banking industry is changed forever In March Bear Stearns fails and is bailed out by having the Fed subsidize its purchase by JP Morgan As mortgage backed securities collateralized debt obligations and credit default swaps begin to default more and more financial institutions around the world face mounting losses The investment banking industry disappears as the last four major investment banks are taken over by commercial banks or go bankrupt In September Lehman Brothers is allowed to go bankrupt Merrill Lynch is purchased by Bank of America with subsidies from the Fed and the remaining two investment banks Goldman Sachs and Morgan Stanley decide to become commercial bank holding companies Congress responds with the bail out bill The Emergency Economic Stabilization Act of 2008 that provides 700 billion to the Treasury for the Troubled Assets Relief Program TARP When the first version of the bill fails to pass Congress on September 29 the Dow Jones Industrial Average has its largest one day point decline of 777 points The Fed responds with new types of loan facilities and by reducing the target for the federal funds rate to historic lows of 0 to 25 in December Barack Obama is inaugurated as president during the worst economic contraction since the Great Depression From the third quarter of 2008 to the second quarter of 2009 GDP declines for four consecutive quarters for the first time since the 1930s Unemployment rates reach 10 2 In response to the Great Contraction Congress passes the American Recovery and Reinvestment Act of 2009 committing 800 billion in stimulus spending The Credit Card Act of 2009 is passed to rein in the worst abuses of the credit card industry The House of representatives passes a financial reform act but the bill dies in the Senate due to heavy lobbying from the financial industry Wall Street executives continue to earn multi million dollar bonuses ECON 162B A0 A1 Fall 2011 Answer Key 3 2 b Henry Paulson was Secretary of the Treasury He was a former CEO of Goldman Sachs where he had been rivals with Lehman Brothers CEO Dick Fuld Paulson allowed Lehman Brothers to fail Ben Bernanke was Chair of the Board of Governors of the Federal Reserve A former Princeton economist he extensively studied the Great Depression Alan Ace Greenberg was the CEO of Bear Stearns His attempts to fight rumors of Bear Stearns collapse backfired and in March 2008 Bear Stearns was the first investment bank to face insolvency It was bailed out through a purchase by JP Morgan Chase Christopher Dodd was the chair of the Senate Banking Committee and he received large campaign contributions from numerous financial institutions and a sweetheart mortgage deal through Angelo Mozillo s Countrywide Mortgage He is one of the namesakes of the Dodd Frank Act c By bailing out the banks the Fed and Treasury risked moral hazard problems If banks believed that taxpayers stood ready to bail them out they would be more likely to make risky decisions If an institution was allowed to fail then policy makers faced a problem of system risk that the failure of one institution may lead to a contagion effect where the whole system collapses d If all institutions were allowed to fail the government would have saved about 300 billion in outlays and it would have avoided the possibility of moral hazard problems But it is likely that the economy would be in much worse shape than it is today During the Great Depression unemployment rates reached 25 much higher than the recent recession 2 There will be many different answers depending on the article used Be sure not to confuse changes in quantity demanded or supplied with changes in demand or supply 3 First set demand equal to supply and solve for Q a 60 3Q 15 2Q 5Q 45 Q 9 P 15 2 9 33 check P 60 3 9 33 b If the demand for bananas increases there will be a shortage at the original equilibrium price The quantity supplied at a price of 33 will remain at 9 but the quantity demanded will become plug price of 33 into new demand curve 33 75 3Q 3Q 42 Qd 14 Since the quantity demanded is 14 but the quantity supplied is only 9 there exists a shortage of 5 units 14 9 This will cause the price to increase as consumers try to outbid each other ECON 162B A0 A1 Fall 2011 Answer Key 3 3 c To find the new equilibrium price and quantity 75 3Q 15 2Q 5Q 60 Q 12 P 75 3 12 39 check P 15 2 12 39 Graphically P 75 60 39 33 S 15 D D 9 12 14 20 37 5 Q 4 a If corn crops are destroyed through floods the supply of corn will decrease Price increases and quantity falls b As store owners purchase plywood the demand for plywood will increase Price and quantity both increase P S S P P Q Q Q D S D D Q Q Q P P P ECON 162B A0 A1 Fall 2011 Answer Key 3 4 c If factory workers are laid off there will be a decrease in the demand for labor Both price and quantity fall d If people don t have time to go to the movies then the demand for movie tickets will decline Both price and quantity will decrease P P P P P P D D Q Q Q D D Q Q Q S S S e Bottled water deliveries will increase the supply of bottled water Price falls and quantity increases P P P S D Q Q Q e An increase in the number of appliances provided by New York State has no effect on the market for nail polish 6 a To find equilibrium set the equations equal to each other and solve for Q 10 000 2Q 1000 Q 3Q 9000 Q 3000 P 10 000 2 3000 4000 P 1000 3000 4000 check b Graphically ECON 162B A0 A1 Fall 2011 Answer Key 3 5 P 10 000 4000 S 4 1000 shortage 3000 D 2000 1000 3000 4000 5000 Q c A price ceiling on rents rent control of 2000 will create a shortage in the market The quantity demanded is given by 2000 10 000 2Q 8000 2Q Qd 4000 The quantity supplied is given by 2000 1000 Q Qs 1000 Since the quantity demanded is 4000 but the quantity supplied is only 1000 there …