Question

A foreign interest rate shock causes the foreign rate or return to exceed the domestic rate of return. Which of the following outlines subsequent effects of this in a fixed exchange rate regime?

		capital inflows cause interest rates to decline boosting domestic investment and economic activity
		capital outflows cause a currency to depreciate improving the trade balance and economic activity
		as unemployment rises workers accept lower wages improving international competitiveness in trade
		capital outflows cause interest rates to rise as the domestic money supply and reserves fall. The economy contracts.

What is the moral hazard of a "too big to fail" policy for bailouts of private banks?

		banks take on higher risk levels knowing that if they are large, concentrated and deeply interconnected that any downside will be born by the government.
		banks will remain small and competitive managing risk cautiously
		banks wary of the downside of risk maintain strong capital buffers against shocks
		highly concentrated banking sectors can manage risk better than others

A sudden stop or reversal of capital flows might be caused by which of the following?

		increase in a countries political risk
		discovery of weak domestic financial institutions who mismanaged risk
		foreign interest rate shock
		all of the above

Some borrowers may take on more risk than lenders would like. This is because the upside of risk is a high rate of return and the downside is a loss to the lender. This type of problem is known as     .

		the principle-agent problem
		original sin
		too big to fail
		moral hazard

Answer 1

Ans. Option b

When rate of return is higher in foreign country, investors move their funds to the other country increasing the net capital outflow from the home country which leads to a decrease in demand for domestic currency depriciating the currency. This increases the demand for exports and decreases the demand for imports increasing the trade balance which increases aggregate demand and hence, increase economic activity

Ans. Option a

Big companies employ large number of people and are an intrgral part of the economy, so, they know that if they were failing, the government fearing large scale unemployment will bail them out. So, they take unreasonablly big risks, this is the moral hazard problem.

Ans. Option d

A sudden fall of capital flow or revesal can be caused if wither investors are earning highet in the other countries or they are not sure of the fundamentals of the country and expect its market to fall which mah be due to political risk or weak financial institutions.

Ans. Option d

Moral hazard is the lack of incentive of to protect from risk if one is protected from the consequences. This may be done by the borrowers because it is not their money on stake.

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