Chapter 14 - Financial Crises, Panics, and Unconventional Monetary Policy
FINANCIAL CRISES, PANICS, AND
UNCONVENTIONAL MONETARY POLICY
NAME: _______________________________________ DATE: ____ / ____ / ____
Give the best answer to each of the following questions.
1. What are the three stages of a financial crisis? Briefly explain how each stage played out
differently during the Great Depression and the Crisis of 2008.
2. Suppose that a certain baseball card increases in price, and that makes collectors want it more
than they previously did. Is this a violation of the law of demand? Why or why not?
3. State whether each of the following is an example of herding, leverage, or extrapolative
expectations:
a. People think it is a good idea to buy Beanie Babies because so many other people are
doing it.
b. As they see the price of Beanie Babies rises, people figure that they must be a wise
investment.
c. People begin to use their credit cards to buy Beanie Babies.
d. People take out loans to buy Beanie Babies.
e. People reason that, since Beanie Babies have increased in popularity so much in just one
year, they will be even more popular in another year.
Chapter 14 - Financial Crises, Panics, and Unconventional Monetary Policy
4. Suppose that, following the example in the question above, people began to use credit cards
and bank loans to buy Beanie Babies, planning on selling the Beanie Babies at a profit before
the credit card payment is due, or before the loan must be paid off.
a. What would happen if suddenly, the price of Beanie Babies stopped rising and even
began to fall?
b. Would this lead to a financial crisis? Why or why not?
5. List and briefly define the four types of unconventional monetary policy the Fed conducted in
response to the financial crisis.
6. For each of the incorrectly-stated criticisms of unconventional monetary policy below, cross
out and rewrite any word or words so that it correctly states a criticism given in the text.
a. "These policies will simply reduce asset prices and prevent the structural adjustments
needed for the U.S. to become competitive."
b. "This policy will allow the government to run large deficits because interest rates on
Treasury securities will be kept too high."
c. "These policies leave the Fed open to enormous profits."
d. "This policy allows the Fed to reverse its stance on the Fed funds rate if it wants to."
Chapter 14 - Financial Crises, Panics, and Unconventional Monetary Policy
Answers to the Problem Set
The following are the correct answers to the problem set that follows on the next two
pages, along with the learning objective associated with each question. The problem set
is designed to be photocopied directly from this book and distributed for student use.
1. (LO1)
In stage one, a bubble forms. During the 1920s, this was a stock market bubble;
during the 2000s, this was a housing bubble. In stage two, the bubble bursts.
Stock market bubbles, like the one in the 1920s, burst more suddenly; housing
bubbles, like the one in the 2000s, burst gradually. In stage three, there is a
financial meltdown. Because in 1929, deposits were not federally insured, there
were runs on banks as people wanted to hoard their cash, which caused banks to
fail; in 2008, the massive amount of leverage that financial institutions had due to
the derivatives and credit default swaps, led the failure of banks to spread
throughout the economy, and financial institutions hoarded cash.
2. (LO2)
No, it is not. The law of demand assumes that other things are constant. In the
example given, the rising price changes the expectations of buyers, so that they
expect the price to rise further. In fact, with any given set of expectations about
the future, the demand curve is still downward-sloping. It just happens that a
rising price causes demand to increase (shift to the right), due to the extrapolative
expectations of the buyers. This creates an upward-sloping “effective” demand
curve.
3. (LO2)
a. Herding; b. Extrapolative expectations; c. Leverage; d. Leverage;
e. Extrapolative expectations
4. (LO2, LO3)
a. If the price of Beanie Babies began to fall, people may not be able to make
their credit card or loan payments.
b. This probably wouldn’t lead to a financial meltdown, because the size of this
market is relatively small. It would have to be that the failure of these
borrowers to pay back their loans had such an impact on financial institutions
that they no longer had money to lend to other firms or individuals, so credit
would freeze. Some creative students may point out that if Beanie Baby
default swaps or other derivatives were sold, it could increase the risk of a
financial crisis.
5. (LO4)
The four types of unconventional monetary policy are:
Quantitative Easing – a policy of targeting a particular quantity of money by
buying financial assets from banks and other financial institutions with newly
created money.
Chapter 14 - Financial Crises, Panics, and Unconventional Monetary Policy
Credit or Qualitative Easing- the purchase of long-term government bonds and
securities from private financial corporations for the purpose of changing the mix
of securities held by the Fed toward less liquid and more risky assets.
Operation Twist – selling short-term Treasury bills and buying long-term
Treasury bonds without creating new money.
Precommitment Policy – committing to continue a policy for a prolonged period
of time.
6. (LO4)
a. reduce prop up
b. high low
c. profits losses
d. allows does not allow