Question

6. Give your definitions of “adverse selection” and “Moral hazard” and discuss briefly the effects of the behavior on the functioning of the financial system.

7. Define the unemployment rate and discuss the factors that may affect the long-term unemployment rate.

8. What are the functions of money? If an economy keeps printing the money how these functions might be affected?

Answer 1

6. Adverse selection occurs when one party has more information as compared to other party leading to negative consequences to the party who doesnt have the information. Suppose you are a chain smoker. Your risk of getting a heart attack is higher than a person who doesn't smoke. As a result, you will buy insurance from an insurance agent. While filling the insurance form, you will not reveal that you are a chain smoker. This a classic example of adverse selection. Most insurance companies face this risk of adverse selection.

The Global Finacial Crisis was a result of adverse selection by the banks. Loans were given recklessly to anybody to buy houses. The Banks went on a loan spree. The borrowers didn't completely reveal their ability to repay the loans. As a result many people couldnt repay the loans leading to the sub prime mortgage crisis of US.

Moral Hazard is a situation wherein an individual enters into a reckless activity when he knows that he is protected against the risk of committing that activity. Suppose You have bought a Home Insurance. You know that if a burglar breaks into your House, your insurance company will pay you the damages. As a result, you stop locking your doors and windows. This is a classic example of moral hazard. Similarly, if you own car insurance, you will start driving recklessly as you know that you are covered under insurance. Whatever damage that happens to the car would be borne by the insurance companies. When you drive recklessly you may hurt yourselves as well as others.

The classic example of Moral Hazard in the financial system is the Bailout of Commercial banks during the Global Financial Crisis. Innocent taxpayers money was used to Bailout the Commercial Banks. These banks know that Government would bail them out in case of emergency, hence they continue to indulge in risky lending.

7. Unemployment rate refers to the total number of people employed divided by the total Labourforce. There are several ways in which unemployment is defined. There is Frictional unemployment, cyclical unemployment, and structural unemployment.

Frictional unemployment exists when people change jobs in the middle. It is also known as search unemployment. It is the time lag between a person switching a job or searching for a job.

Cyclical unemployment occurs when there is a lack of demand for goods and services in the economy. Its called cyclical employment because it changes according to the business cycles.For eg: during recession unemployment rate rises at a very fast rate.

Structural unemployment occurs when there is no demand for goods and services for a very long time. It also occurs when there is a mismatch of skills that workers have and the skills that the employers require. Due to growing technology, structural unemployment is rising.

Factors that affect unemployment in the Long Run are:

a) Slow rate of Economic Growth: When the growth rate of the economy is less, production reduces. As a result, lesser people are employed.

b) Unemployment rises due to Sticky wages. During a depression, employers are not ready for a wage cut, as a result, many employees are laid off. This increases the unemployment rate.

c) Improvement in Technology: Technology acts as a double-edged sword. It creates a lot of employment opportunities, at the same time many old jobs become redundant due to the development of technology. Initially, there were cashiers at the banks, With the invention of Automated Teller Machines (ATM's), the Cashiers have started losing their jobs.

d) Weather also plays an important role in unemployment. Certain jobs can be done only during a particular season. After the season gets over people working in that sector lose their job.

e) When the government keeps the wages very high, many people want that particular job. Not all people get employed. This leads to rising unemployment rate. This is also called as institutional unemployment.

8. Money is a matter of functions Four, a medium, a measure, a standard a store.

a) Money is a medium of exchange. It helps us to buy different goods and services. If there was no money, we would have been under barter system. The biggest problem of a barter system is the double coincidence of wants. Suppose you want a kilo of Rice and you have a cow as an asset. You cannot give away your entire cow for 1 kilo of rice. Money conveniently eliminates all the problems related to the Barter system.

b)Money is a measure of Value: All the goods and services can be measured easily in terms of money. Under Barter system it is very difficult to determine the value of different goods and services.

c)Money is a standard of deferred payments: Deferred payments are those payments which we make in the future. Under Barter system there was no question of future payments. we cannot use present day apples and oranges to pay for our future debts.

d) Money is a store of Value: Money can be easily stored for future transactions. For eg: Under Barter system , suppose a farmer only has apples and oranges. He cannot save apples and oranges for the future consumptions. It will rot and will lose all its economic value. Thus Money can be easily stored and can be used for future consumption.

If the economy keeps on printing money , money supply in the economy starts rising. As a result people have more disposable income in their hands. Their Demand for goods and Services starts rising. As a result the prices of goods and services starts rising leading to inflation. Inflation reduces the value of money. As a result money can only buy lesser number of goods and services. Value of money starts declining. Thus the store of value function is highly affected during inflation.