Understanding Adverse Selection

1663 Words Jul 1st, 2011 7 Pages
Clara Rodriguez
Assignment 1

Assignment 1

1. Because there is an imbalance of information in a lending situation, we must deal with the problems of adverse selection and moral hazard. Define these terms and explain how financial intermediaries can reduce these problems.

Definitions:

Adverse selection- this is a condition which acknowledges that people with more risky project are more likely to ask for loans and there is an information asymmetry present. To reduce the risks associated with adverse selection risk evaluation needs to be as accurate as possible and screening for services successful. Moral hazard- this refers to a situation where one party is more informed than the other party. This can be applied to a
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However, data indicates that the interest rate is procyclical; it rises during economic expansions and falls during recessions (Mishkin, 108).
During a recession income and wealth decrease, as a result there is an inward shift of the demand curve for bonds. This shift results in an increase in interest rates. When the economy is booming there is an increase in the demand for bonds. This increase in bond demand shifts the demand right from P1 to P2, this shift will increase the interest rate.

Bond market: description of a Booming economy and government deficit

Price of bonds, P 1000 800

600

i= 0

5.3

17.6

33.0%
Bs1

Bs2

P1

P2

Bd2

Bd1

Quantity of bonds, B
($ Billions)

Keynes’ Liquidity Preference Framework: determines interest rate in terms of supply and demand for money * = opportunity cost of spending money is higher, the quantity of money demanded is low as a result of higher interest rates * = market clearing point interest rate = 15% and money supply is 400 = an increase in income will shift the demand curve outward to Md1

= lower level of income shifts demand curve inwards to Md2

Equilibrium in the Money Market

Interest rate, I (%)

Ms
30
25
20
15
10
5

Md1 Md2
Md

0 100 200 300 400 500
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