Question

Question 5
Discuss the role of asymmetric information in causing financial frictions and subsequently
financial crises.

Question 6
Assume that currently the discount rate is 3%, the federal fund rate 3% and the interest rate on
reserves is 0.5%. Suppose the Federal Reserve wants to lower the federal funds rate. Which of
the following policy tools is more effective, a change in discount rate or a change in the interest
rate on reserves? Use a supply and demand for reserves diagram to explain your answer.

Question 7
Suppose the Federal Reserves is following the Taylor rule. The economy is thought to be 2
percent below potential (i.e., the output gap is −2 percent), and the inflation rate was 3 percent
over the past year. The federal funds rate is currently 3 percent. The equilibrium real fed funds
rate is 3 percent and the weights on the output gap and inflation gap are 0.5 each. The inflation
target is 1 percent.
a) Is the federal funds rate currently too high or too low? By how much? Show your work.

b) Suppose a year has gone by, output is now 3 percent above potential, and the inflation
rate was 4.5 percent over the year. What federal funds rate should the Federal Reserve
now set (assuming the inflation target does not change)? Show your work.
c) What challenges do policymakers and researchers face in using the Taylor rule?

Question 8
a) Suppose an economy was originally operating at potential output. Unfortunately, a pandemic
outbreak caused the stock market to crash. In face of such shock, describe how activist
monetary policy makers would respond to stabilize the economy. Explain your answer with
an aggregate demand-aggregate supply diagram.
b) Nonactivists argue that government action is unnecessary to eliminate the fluctuations in the
economy caused by the stock market crash. Justify their argument.

Answer 1

                                    Asymmetric information in economics refers to a condition where one party in an economic transaction has more knowledge than the other party of the financial transaction that takes place between them. It occurs in all forms of market activity of an economy like financial market, labour market, insurance market etc. The following are the disadvantages of asymmetric information in an economy

· It may lead to an increase of fraudulent activities like adverse selection and moral hazards in the economy as wither the seller or a buyer of an economy has more information about the traded commodity whether it is a good, service or money. Insider trading in stock market is an example of this where the company offering IPO would have lesser profits due to information leakage.

· It will lead to an increased cost of goods and services in the market.

· It would lead to lender-borrower dilemma’s in the financial market. When the borrower has more information than the lender, the lender would face a difficulty to judge whether the borrower would default or not in the future.

· In the Insurance market, if the patient fails to or knowingly hides a relevant data, the insurance company would have to suffer by incurring increased costs in the future. If many such cases occur, it would lead to failures of the insurance firm.

· The lack of knowledge about the working attitude of an employer would have consequences on the production output of a firm

                                                  Asymmetric information refers to a long standing phenomenon as discussed above. As it is seen, almost all the sectors of an economic system faces this problem of asymmetric information. Thus, due to lack of this information of one party, the other party would get an advantage in a market system that would lead to unfair competitions Once the fairness of competition is not maintained in many sectors of the economy, It would lead to fraudulent activities and profit raising activities in the economy which would lead to crash of any sector or a group of sectors causing financial frictions in the economy at once and would finally result in a financial crisis.