Question;Econ 451Fall 2014Homework 1Instructions:? You need to use the concepts and theories we discussed in class to answer thequestions.? Use bullet-point style to outline your arguments.1. Suppose you go to a bank, intending to buy a one-year certificate of deposit that pays anannual interest rate of 2% with your savings. At the bank, you run into a stranger whohappens to be at the bank applying for a car loan which the bank charges him an annualinterest rate of 8%. Give two reasons why you would not offer a loan to the car loanapplicant that would significantly increase the return of your savings (close to 8%).Assume that your savings are sufficient to cover his car loan.2. What is the adverse selection problem on the corporate bond market?3. (a) What is the net worth of a firm?(b) Explain why the net worth of a potential borrower can be used to overcome boththe adverse selection and moral hazard problem for a loan.4. A central bank serves as the ?lender of last resort? for the commercial banks by offeringadditional funding to troubled banks. Explain how this extra insurance can exacerbatethe moral hazard problem in the banking industry. (Note that you need to explain themoral hazard problem without the central bank, and why the problem is worse withaccess to the central bank?s lending.)5. You are hiring Bob to manage your business. If Bob works hard, the business would yieldan expected net profit of $30,000. If Bob is lazy, the business would yield an expectednet profit of $20,000. You do not observe if Bob works hard or not, nor you can inferfrom the actual net profit if Bob has worked hard or not since the business is inherentlyrisky. Bob view working hard as a ?personal cost? valued at $1,000. Assume Bob caresonly about his expected payment less any ?personal cost.?(a) Would offering Bob an additional $1,000 in pay sufficient to induce him to workhard? Why?(b) How about offering Bob a fixed percentage of profit? If the answer is yes, what is theminimum percentage you should offer to induce him to work hard? Explain.
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