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Why are policy makers more concerned about the financial market than other markets such as the automobile or computer markets?
The financial market employs the most people in the economy.
A working financial market is essential for all other sectors of the economy to function.
The government controls the sector; it doesn't control the other sectors.
The financial market produces the most goods in the economy.
Multiple Choice Learning Objective: 15-1 Section: Why Are Financial Panics Scary?
True or false? The 1929 stock market crash is the single cause of the Great Depression. Explain.
False. While the stock market crash in 1929 pushed the economy into a recession, the ensuing World War pushed the economy into a depression.
True. The stock market crash in 1929 led to an immediate and deep depression because the financial sector is the largest sector of a modern economy.
False. While the stock market crash in 1929 pushed the economy into a recession, the financial meltdown that followed the crash pushed the economy into
the depression.
True. The stock market crash in 1929 led to an immediate and deep depression because real wealth declined, leading to a dramatic decrease in aggregate
demand.
Multiple Choice Learning Objective: 15-2 Section: The Great Depression
How did depositors loss of trust in banks contribute to the depression?
Rumors of bank failures and loss of trust led depositors to withdraw their funds and caused some banks to fail. Other banks hoarded cash to guard against
such possibilities, which decreased funds available for lending. As a consequence firms could not borrow or invest. Without this investment, they laid off
workers. Lower employment led to lower aggregate expenditures.
Rumors of bank failures and loss of trust did not contribute to the Depression. The Depression was caused by the onset of World War II.
Rumors of bank failures and loss of trust did not contribute to the Depression. The Depression was caused by the stock market crash of 1929.
Rumors of bank failures and loss of trust led employees to look for other work, which created a shortage of loans. As a consequence firms could not borrow
or invest. Without this investment, they laid off workers. Lower employment led to lower aggregate expenditures.
Multiple Choice Learning Objective: 15-2 Section: The Great Depression
What are the two ingredients that caused the stock market bubble in 1920 and early 2000s?
Securitization
Herding
Derivatives
Leverage
Check All That Apply Learning Objective: 15-3 Section: Understanding the 2008 Financial Crisis
How do extrapolative expectations contribute to the shape of the demand curve in a market with a bubble?
Increases in prices lead demanders to demand more. This shift in the demand curve leads to even higher prices, which causes a further shift in the demand
curve. As prices rise, demand increases causing the effective demand curve to be upward sloping.
Increases in prices lead do not affect demanders, leading suppliers to increase price even more. This means the effective demand curve is vertical.
Increases in prices lead demanders to demand more. This shift in the demand curve offsets the price increases, setting in motion a steep decline in prices.
As prices rise, demand increases causing the effective demand curve to be steeply downward sloping.
Increases in prices lead demanders to demand less. This shift in the demand curve offsets the initial increase causing the effective demand curve to be
horizontal.
Multiple Choice Learning Objective: 15-4 Section: Understanding the 2008 Financial Crisis
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What is leveraging?
Lending at very high interest rates.
Using past experience to pick stocks in the future.
Basing future prices on past price behavior.
Borrowing for the purpose of making financial investments.
Multiple Choice Learning Objective: 15-4 Section: Understanding the 2008 Financial Crisis
What does it mean to securitize a loan?
The process of securing the funds to purchase stocks.
The process of bundling several loans together into a new financial instrument called a security and for the purpose of selling that security.
The process of adding a lien on the assets of borrowers so that if they default on the loan the bank gets the assets.
The process of re-selling a single loan to another financial institution. Legally, a loan must be securitized before it is sold.
Multiple Choice Learning Objective: 15-5 Section: Understanding the 2008 Financial Crisis
How do mortgage-backed securities provide both diversification and liquidity?
Mortgage backed securities provide neither diversification nor liquidity. That is the lesson of the recent mortgage crisis.
Mortgage backed securities provide diversification because the securities are bundles of mortgages from different markets that are subject to different
economic conditions. They provide liquidity because there is a nationwide market for mortgage-backed securities.
Mortgage backed securities provide diversification because more than one institution holds them. They provide liquidity because they can be traded for other
mortgages without having to be re-issued.
Mortgage backed securities provide diversification because the assets by which they are backed vary. They provide liquidity because they are backed by real
assets that can be easily sold.
Multiple Choice Learning Objective: 15-5 Section: Understanding the 2008 Financial Crisis
How does leverage work in reverse to hasten the bursting of a bubble?
Leveraging doesn't lead to a faster bubble. It slows the bursting of bubbles.
Leveraging leads to a faster bursting of a bubble because borrowers sell their loans to hold onto the real assets that backed those loans because their
prices are not falling.
Leveraging leads to a faster bursting of a bubble because people realize that they mistakenly leveraged their experience and must come up with new rules of
thumb.
Leveraging leads to a faster bursting of a bubble because the borrower must sell the asset whose price is falling to repay the loan.
Multiple Choice Learning Objective: 15-4 Section: Understanding the 2008 Financial Crisis
How does a decline in aggregate demand in the depression model lead to a spiraling decline in the price level and output?
A decline in aggregate demand is met with a drop in prices, which leads suppliers to supply less. This leads to a downward spiral that is never-ending, at
least until the quantity of aggregate supply and aggregate demand cease to be affected by the price level.
A decline in the quantity of aggregate demand leads to lower prices, which leads aggregate supply to shift to the left. The downward spiral is never-ending, at
least until the dynamic between the two no longer exists.
A decline in the price level leads aggregate demand to shift to the left, which leads aggregate supply to shift to the left as well. The downward spiral is never-
ending, at least until the dynamic between aggregate supply and demand no longer exists.
Shifts in aggregate demand trigger additional shifts in aggregate demand, so the downward spiral is never-ending, at least until the dynamic between the two
no longer exists.
Multiple Choice Learning Objective: 15-4 Section: Understanding the 2008 Financial Crisis
What are the three stages of dealing with a financial crisis?
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Triage
Revamping
Treatment
Rehabilitation
Decompression
Check All That Apply Learning Objective: 15-6
Section: How Do Economies Get Out of a Financial
Crisis?
What policy actions are involved in each of the three stages of dealing with a financial crisis?
Set up regulations to stabilize the markets for the future. (Click to select)
Prevent a complete collapse of the financial markets. (Click to select)
Fiscal stimulus. (Click to select)
Worksheet Learning Objective: 15-6
Section: How Do Economies Get Out of a Financial
Crisis?

What are three financial triage actions government took in response to the financial crisis in 2008?
Loans
Expansionary fiscal policy
Guarantees of loans and financial instruments
Buying stock in automobile companies
Investments in financial institutions
Check All That Apply Learning Objective: 15-6
Section: How Do Economies Get Out of a Financial
Crisis?
What is the moral hazard problem and what does it have to do with banking?
A problem that arises when one does not bear the consequences of ones actions. Insuring deposits leads depositors to deposit money into riskier
institutions because they cannot lose their money.
The problems that arise when financial institutions find ways to circumvent government regulations. Circumventing regulations, even when done legally, can
jeopardize the financial sector.
When CEOs of financial institutions are given year-end bonuses when stock prices are declining. End-year bonuses reduce the financial assets held by
banks.
The hazard of trading stocks unethically. The hazard is getting caught and found guilty in a court of law. Unethical behavior can lead to a financial collapse and
a withdrawal of bank deposits.
Multiple Choice Learning Objective: 15-6
Section: How Do Economies Get Out of a Financial
Crisis?
What is the law of diminishing control?
Any regulatory system can most effectively control large financial institutions. Its control of smaller institutions diminishes with their size.
Whenever a regulatory system is set up, individuals or firms being regulated will figure out ways to circumvent those regulations.
The effect of regulations diminishes as securities are sold from one party to another.
As time goes by, the regulators who established the laws retire and new regulators are less likely to enforce the original regulations. Regulation diminishes.
Multiple Choice Learning Objective: 15-7
Section: How Do Economies Get Out of a Financial
Crisis?
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What is the bad precedent problem in relation to financial bubbles?
When one lender leverages stock purchases, others follow suit.
People see others buying stocks whose prices are rising, so they do too.
When a bubble bursts, people come to expect more frequent bubble bursts.
When a government bails out one sector, it will be under political pressure to bail out others.
Multiple Choice Learning Objective: 15-7
Section: How Do Economies Get Out of a Financial
Crisis?
What is the too big to fail problem?
If a mortgage exceeds a conforming loan limits, banks are legally not able to foreclose on that loan. This leads buyers to look for larger homes.
If a bank has a large asset base, in excess of its liabilities, it will be too big to fail. Government encourages financial institutions to be too big to fail.
If a bubble is large enough, government will step in to buy financial securities too keep the bubble from bursting.
If banks are too big to fail, then the government will be forced in to bail them out if they do. This creates a moral hazard for banks that know they will be bailed
out, and leads them to take excessive risks.
Multiple Choice Learning Objective: 15-7
Section: How Do Economies Get Out of a Financial
Crisis?