1) You are in the market for a used car. At a used car lot, you know that the blue book value for the cars you are looking at is between $20,000 and $24,000. If you believe that the dealer knows as much about the car as you, how much are you willing to pay? Why? Assume that you care only about the expected value of the car you buy and that the care values are symmetrically distributed.
Now, you believe the dealer knows more about the care than you. How much are you willing to pay? Why?
2) Define financial frictions and explain why an increase in financial frictions a key element in financial crises is. How does a general increase in uncertainty as a result of a failure of a major financial institution lead to an increase in adverse selection and moral hazard problem?
3) If the Fed sells $2 million of bonds to the First National Bank, what happens to reserves and the monetary base? Use T-accounts to explain your answer.
4) If a switch occurs from deposits into currency, what happens to the federal funds rate? Use supply and demand analysis of the market for reserves to explain your answer.
