Macroeconomics 6th Edition Blanchard

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Macroeconomics, 6e (Blanchard/Johnson)
Chapter 9: The Crisis

9.1 Multiple Choice Questions

1) The Case-Shiller index is normalized to equal 100 in January

A) 1999.
B) 1990.
C) 2000.
D) 2001.
Answer: C
Diff: 1

2) The Case-Shiller index reached its peak in

A) 2006.
B) 2007.
C) 2005.
D) 2008.
Answer: A
Diff: 1

3) By 2006, about ________ of all U.S mortgages were subprimes.

A) 10%
B) 20%
C) 30%
D) 25%
Answer: B
Diff: 1

4) The mortgage is said to be underwater when

A) the value of the house exceeds the value of the mortgage.
B) the house is flooded.
C) the value of the mortgage exceeds the value of the house.
D) none of the above
Answer: C
Diff: 1

5) In mid-2008, estimated losses on mortgages were estimated to be about ________ of U.S.

GDP.
A) 2%
B) 5%
C) 7%
D) 9%
Answer: A
Diff: 1

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6) Which of the followings is NOT a bank's assets?
A) reserves
B) loans
C) government bonds
D) checkable deposits
Answer: D
Diff: 1

7) Suppose bank A has assets of 100, liabilities of 80, and capital of 20. Its capital ratio is
A) 20%.
B) 25%.
C) 11%.
D) 10%.
Answer: A
Diff: 1

8) Suppose bank A has assets of 100, liabilities of 80, and capital of 20. Its leverage ratio is
A) 4.
B) 5.
C) 10.
D) 9.
Answer: B
Diff: 1

9) Suppose bank A has assets of 100, liabilities of 60, and capital of 40. Its capital ratio is
A) 40%.
B) 66%.
C) 25%.
D) 60%.
Answer: A
Diff: 1

10) Suppose bank A has assets of 100, liabilities of 60, and capital of 40. Its leverage ratio is
A) 1.5.
B) 2.5.
C) 0.6.
D) 0.4.
Answer: B
Diff: 1

11) The first structured investment vehicle (SIV) was set up by ________ in 1988.
A) J.P. Morgan
B) Chase
C) Citigroup
D) Goldman Sachs
Answer: C
Diff: 1
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12) AIG provide CDS against
A) insolvency.
B) default risk.
C) illiquidity.
D) none of the above
Answer: B
Diff: 1

13) Securitization can NOT help financial intermediaries

A) diversify their portfolios.
B) avoid bankruptcy.
C) attract more investors to buy and hold their securities.
D) decrease the cost of borrowing.
Answer: B
Diff: 1

14) Collaterailzed debt obligations (CDOs) were first issued in

A) 1980s.
B) 1990s.
C) 2000.
D) 2001.
Answer: A
Diff: 1

15) Ted spread is

A) the difference between the riskless rate and the rate at which banks are willing to lend to each
other.
B) the difference between the riskless rate and the yield on corporate bonds.
C) the difference between the riskless rate and return on stocks.
D) none of the above
Answer: A
Diff: 1

16) FDIC deposit insurance is ________ per account.

A) $100,000
B) $150,000
C) $200,000
D) $250,000
Answer: D
Diff: 1

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17) ________ was introduced in October 2008 to clean up banks.
A) liquidity facilities
B) wholesale funding
C) TARP
D) fire sale
Answer: C
Diff: 1

18) American Recovery and Reinvestment Act 2009 calls for

A) both tax reductions and government spending reductions.
B) both tax reductions and government spending increases.
C) both tax increases and government spending increases.
D) both tax increases and government spending reductions.
Answer: B
Diff: 1

19) Firms with _____ratings are considered the safest.

A) AAA
B) BBB
C) CCC
D) BB
Answer: A
Diff: 1

20) LIBOR rate is

A) interbank loan rate.
B) the riskless rate.
C) TED spread.
D) discount rate.
Answer: A
Diff: 1

21) Which of the following conditions will most likely coincide with the existence of a liquidity
trap?
A) inflation is rising
B) inflation is constant
C) inflation is zero
D) individuals prefer to hold only money and not bonds
E) the real interest rate is negative
Answer: D
Diff: 1

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22) When a liquidity trap situation exists, we know that
A) an open market operation will have no effect on the supply of money.
B) an open market operation will have no effect on the monetary base.
C) fiscal policy will have no effect on the demand for goods.
D) expansionary monetary policy will be deflationary.
E) none of the above
Answer: E
Diff: 1

23) Suppose a liquidity trap situation exists. Which of the following is most likely to occur if
taxes are cut?
A) no change in output and no change in the interest rate
B) an increase in output and an increase in the interest rate
C) an increase in output and little change in the interest rate
D) an increase in output and a reduction in the interest rate
E) none of the above
Answer: C
Diff: 1

24) An open market purchase of bonds by the central bank will cause which of the following
when a liquidity trap situation exists?
A) the interest rate will decrease.
B) the interest rate will not change.
C) output will increase.
D) the money supply, M, will not change.
E) none of the above
Answer: B
Diff: 1

25) An open market sale of bonds by the central bank will cause which of the following when a
liquidity trap situation exists?
A) the interest rate will increase
B) the interest rate will not change
C) output will decrease
D) the money supply, M, will not change
E) none of the above
Answer: E
Diff: 1

26) Which of the following will occur when an economy is faced with a liquidity trap situation?
A) a reduction in the price level will cause a rightward shift in the aggregate demand curve
B) a reduction in the price level will cause a leftward shift in the aggregate demand curve
C) the aggregate demand curve is now vertical
D) the aggregate demand curve is now upward sloping
Answer: C
Diff: 1

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27) The primary cause of the reduction in the nominal money supply during the early years of
the Great Depression was
A) the Fed's sale of bonds
B) the Fed's purchase of bonds
C) a reduction in the money multiplier
D) none of the above
Answer: C
Diff: 1

28) When a liquidity trap situation exists, the most appropriate policy to increase output would
be
A) a central bank sale of bonds.
B) an increase in government spending.
C) a central bank purchase of bonds.
D) none of the above
Answer: B
Diff: 1

29) The reduction in Japanese stock prices in the 1990s was most likely the result of which of the
following?
A) contractionary monetary policy
B) contractionary fiscal policy
C) the end of a speculative bubble
D) an increase in inflation
Answer: C
Diff: 1

30) One of the possible solutions for the Japanese slump is to

A) implement macroeconomic policies to create inflation.
B) maintain a constant aggregate price level.
C) maintain the real interest rate at its original level.
D) none of the above
Answer: A
Diff: 1

31) The Nikkei, a Japanese stock price index, reached its peak in which of the following years?
A) 1980
B) 1985
C) 1989
D) 1992
E) 1995
Answer: C
Diff: 1

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32) Which of the following has been suggested as a possible solution to the Japanese slump?
A) disinflationary macroeconomic policy
B) budget deficit reduction packages
C) banking reform
D) all of the above
E) none of the above
Answer: C
Diff: 1

9.2 Essay Questions

1) Was the sharp house price increase from 2000 to 2006 justified?
Answer: Some increase in prices was clearly justified: The 2000s were a period of unusually
low interest rates. As a result, mortgage rates were also low, increasing the demand for housing
and thus pushing up the price. Other factors were also at work. Mortgage lenders became
increasingly willing to make loans to more risky borrowers, increasing the demand for housing.

2) Capital can help prevent banks from bankruptcy. Explain why things can still go wrong even
if a banks holds some capital.
Answer: First, the assets may decline in value by so much that the capital the bank holds is not
enough to cover losses. Second, the bank may be still solvent but become illiquid.

3) First, explain leverage ratio. Second, discuss why banks had high leverage ratio.
Answer: Leverage ratio is defined as the ratio of assets to capital. There appears to be a number
of reasons why banks had high leverage ratio: First, banks probably underestimated the risk they
were taking.
Second, the compensation system and bonus payments also gave incentives to managers to go
for high expected returns without fully taking the risk of bankruptcy into account. Third, while
financial regulation required banks to keep their capital ratio above some minimum, banks found
new ways of avoiding the regulation, by creating new financial structures such as SIVs

4) Explain securitization and its advantages.

Answer: Securitization is the creation of securities based on a bundle of assets (for example, a
bundle of loans, or a bundle of mortgages).For instance, a mortgage-based security, or MBS for
short, is a title to the returns from a bundle of mortgages, with the number of underlying
mortgages often in the tens of thousands. The advantage is that many investors, who would not
want to hold individual mortgages, will be willing to buy and hold these securities. This increase
in the supply of funds from investors is, in turn, likely to decrease the cost of borrowing.

5) What were the immediate effects of the financial crisis on the macro economy.
Answer: The immediate effects of the financial crisis on the macro economy were two-fold:
first, a large increase in the interest rates at which people and firms could borrow; second, a
dramatic decrease in confidence.

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6) Discuss the initial policy responses to the financial crisis.
Answer: 1) In order to prevent a run by depositors, federal deposit insurance was increased from
$100,000 to $250,000 per account. 2) The Fed provided widespread liquidity to the financial
system.3) The government introduced a program, called the Troubled Asset Relief Program,or
TARP, aimed at cleaning up banks. 4) The Fed decreased interest rate to zero. 5) In terms of
fiscal policy, US government used a combination of reductions in taxes and increases in
spending: The American Recovery and Reinvestment Act, was passed in February 2009. It called
for $780 billion in new measures, in the form of both tax reductions and spending increases, over
2009 and 2010.

7) Suppose a liquidity trap exists. Graphically illustrate and explain the effects of an increase in
money supply using the IS-LM model.
Answer: Given that the liquidity trap already exists, we know that the equilibrium in the IS-LM
model occurs where the IS curve intersects the LM curve on the horizontal portion of the LM
curve. When M increases,any increase in the money supply will simply be held by individuals
and i will not fall.

8) Suppose a liquidity trap exists and output is below its natural level. Graphically illustrate and
explain if the economy can return to its natural level using the AS-AD model.
Answer: Given that the liquidity trap already exists, we know that AD curver is vertical. As
output is below
its natural level, the aggregate supply curve shifts down over time. The price level keeps
decreasing, but this does not lead to an increase in output.

9) Explain what is meant by the liquidity trap. Also discuss the implications of a liquidity trap for
the shapes of the money demand and LM curves.
Answer: A liquidity trap occurs when the nominal interest rate equals zero and, therefore, can no
longer fall. Usually, when there is an increase in the money supply, there would be an excess
demand for bonds, an excess supply of money and the interest rate would fall. When i = 0, the
return on bonds and money is the same. So, any increase in the money supply will simply be held
by individuals and i will not fall. This implies that the money demand curve becomes horizontal
at the zero interest rate. It also implies that LM curve becomes horizontal at the zero interest rate.

10) Suppose a liquidity trap exists. Graphically illustrate and explain the effects of an increase in
government spending using the IS-LM model.
Answer: Given that the liquidity trap already exists, we know that the equilibrium in the IS-LM
model occurs where the IS curve intersects the LM curve on the horizontal portion of the LM
curve. When G increases, demand will increase. The IS curve will shift to the right causing an
increase in output. The interest rate will either not increase (because we are still operating in the
presence of a liquidity trap) or increase.

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11) To what extent can a deflation and the presence of a liquidity trap explain the Japanese
slump? Explain.
Answer: Both the deflation and liquidity trap can explain the Japanese slump. We have observed
sluggish or negative growth with low inflation or deflation. The destabilization effects of
deflation certainly can apply to Japan. Furthermore, with nominal interest rates approaching
zero, a liquidity trap may also exist where the Japanese central bank cannot increase output
because it cannot push the nominal interest any lower.

12) To what extent have monetary policy and fiscal policy been able to limit the severity of the
Japanese Slump? Explain.
Answer: The response of monetary policy was likely too late. Once monetary policy responded,
the extremely low nominal interest rates made it difficult for monetary policy to have much of an
impact. Fiscal policy has also been less than successful. As noted in the chapter, the increases in
government spending have been on public works type programs that have been questionable.

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