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Unformatted text preview: CHAPTER 2 ANSWERS 2-1 Financial intermediaries are business organizations that receive funds in one form and repackage them for use by those who need funds. Through financial intermediation, resources are allocated more effectively, and the real output of the economy is thereby increased. 2-2 Regional mortgage rate differentials do exist, depending on supply/demand conditions in the different regions. However, relatively high rates in one region would attract capital from other regions, and the end result would be a differential that was just sufficient to cover the costs of effecting the transfer (perhaps 1/2 of one percentage point). Differentials are more likely in the residential mortgage market than the business loan market, and not at all likely for the large, nationwide firms, which will do their borrowing in the lowest -cost money centers and thereby quickly equalize rates for large corporate loans. If banks are permitted to engage in unrestricted nationwide branch banking, then rates probably would be more uniform because there would be a tendency for large, efficient banking organizations to evolve. 2-3 It would be difficult for firms to raise capital. Thus, capital investment would slow down, unemployment would rise, the output of goods and services would fall, and, in general, our standard of living would decline. 2-4 The prices of goods and services must cover their costs. Costs include labor, materials, and capital. Capital costs to a borrower include a return to the saver who supplied the capital, plus a mark-up (called a spread) for the financial intermediary that brings the saver and the borrower together. The more efficient the financial system, the lower the costs of intermediation, the lower the costs to the borrower, and, hence, the lower the prices of goods and services to consumers. 2-5 Short-term rates are more volatile because (1) the Fed operates mainly in the short-term sector, hence Federal Reserve intervention has its major effect here, and (2) long-term rates reflect the average expected inflation rate over the next 10 to 30 years, and this average does not change as radically as year-to-year expectations. 2-6 Interest rates will fall as the recession takes hold because (1) business borrowings will decrease and (2) the Fed will increase the money supply to stimulate the economy. As a result, it would be better to borrow short-term now, and then to convert to long-term when rates have reached a cyclical low. Note, however, that this answer implies interest rate forecasting, which is extremely difficult to do. 2-7 A significant increase in productivity would raise the rate of return on producers investments, thus causing the investment curve (see Figure 2-2 in the textbook) to shift to the right. This would increase the amount of savings and investment in the economy, thus causing all interest rates to rise....
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