Just as it has been indicated in the article, it is the human nature to try and avoid any undertakes that looks risky or else that can lead to loses instead of profits. So, the same case applies to this scenario equally. If the asset is perceived to be risky, then people will be highly suspicious to engage in any exchange that relates to such an asset. As a result, its demand in the market will definitely be low.
The key factor behind its low demand in the market here is the risk and that means if the risk factor is waved away, its demand will definitely increase (Adelaide, Adelaide and Australia.Siddiqi, 2017). The first scenario has been represented by the first curve labeled “Risky Asset” while the second scenario has been represented by the second curve which is labeled “Risky free Asset”.
In the first scenario “Risky Asset”, it is clearly evident that the supply for the asset is considerably higher than its demand. This is as a result of the fact that people are quite suspicious in engaging in such an asset trade because of the fear that they might end up losing their investments on it as it can be seen where supply is at 1 unit, the demand is less than 1 unit.
However, things take a different route when the status of the asset changes to “Risky free” as shown in the second curve (Adelaide, Adelaide, and Australia.Siddiqi, 2017). This is because the mental aspect of probable loses when investing in such an asset disappears and therefore people can engage in any business or trade involving the asset. This has been indicated in the second curve where supply is 1 unit, demand, on the other hand, ranges at the same unit or even high.
Part 2: What happens when the asset in “part a”, is suddenly revealed to be risky?
When the asset is suddenly revealed to be risky, definitely those who had already purchased it for trade purposes will rush out quickly for purposes of looking for any possible approach to mitigate the risk. This has been well elaborated in the article where people have been pointed out as beings with a high disproportionate preference for safety (Adelaide, Adelaide, and Australia.Siddiqi, 2017).
In their attempt to divert the risk, there are high chances that they would dispose of the asset at the same price they acquired it with or even lower in order to attract any potential buyer easily. The whole cycle will be necessitated by the need to ensure that the identified potential losses do not befall them but other parties.
For that matter, the demand and supply curve for this asset is likely to undergo an abrupt change indicated below after sometime after revelation that its risky since people would have disposed it and the demand would have gone low as indicated in the graph below.
Part 3: Suppose the banking sector raises money by selling such financial assets to investors. For the banking sector as well as for investors in general, discuss the macroeconomic implications of incorrectly perceiving risky financial assets as risk-free What happens when the truth about such assets is suddenly revealed?
After banks make huge amounts by selling these types of assets to other banks and investors, they will be in a position of making other new loans with the money they receive. They may also collect payments from traders, but send them along to the hedge funds, who in turn will send it to the investors. In this case, everyone in the chain is entitled to a share along the way which makes it desirable to engage in. The investors fail to understand that the trade is only risk-free for banks and other financial institutions
On their side, the investors are the bearers of all the risks in default. They may, however, resolve to insure themselves through credit default swaps which are mainly sold by solid insurance companies. Because of the courage of the insurance company, the investors will snap up more assets. In time, everyone is expected to own the assets including the pension funds, hedge funds large banks and even individual investors
Because the asset transaction will have been backed up by its industry and insurance, its trade will be highly profitable. As a result, the demand for the asset will also be followed by a significant bank demand for more of the asset to back up the securities. For this increasing demand to be met, banks and other asset brokers will begin offering loans to almost everyone interested in the venture. From an economic point of view, this will lead to an increased money supply in the economy and the end result will be an automatic inflation
Question 2
Part 1: In this course, we studied the impact of tariffs on imports. Consider the market for beef in China, and, analyze what happens in this market, when China eliminates tariffs on beef imports from Australia (Hint: Do a welfare analysis. That is, calculate the total surplus before and after tariff removal).
Tariffs are in the category of barriers to trade because it discourages trade between two countries especially when such tariffs are very high. Mainly, tariffs increase the prices of imports because their value must always be included in the final price and that reduces the purchasing power of consumers. For instance, if a certain product was supposed to be sold at a value X without tariffs when tariffs are enacted at a value of Y, the final price for this commodity in the new market will therefore be (Howe, 2015)
Final price= X (the initial price before Tariff enactment) + Y (the tariff value)
Basically, tariffs make the prices of goods and services to be high. That, in turn, reduces the purchasing power of consumers compared to when the prices are low. So, in a case where the tariffs are eliminated, traders will be willing to import more compared to when the tariff was still applicable (Howe, 2015).
Part 2: By citing evidence from the article, make a case that the argument in part “a” above is not entirely correct? Explain
Removing tariffs on imports may not always mean that the importation sector will have to enjoy the advantages of the matter. This is especially in the cases where the FTA does not apply to only one country but to many. For instance, in the case of China has removed the tariff not only to Australia but also to other countries like ASEAN, New Zealand, and Chile. If it happens that one of these other beneficiaries of tariff removal produces the same products at a lower cost, then it will definitely not have a positive impact on the Australian imports if they are produced at a higher cost. This will imply a continuous struggle for market share in China (Howe, 2015).
Question 3
Part a: The authors write that ‘..research shows that debt contracts have large negative
externalities on the economy that are not properly priced among private parties’. Using the concept of externalities studied in this course, explain the authors’ statement.
First of all, negative externalities are the costs which are incurred by third parties due to economic transactions. In any transaction, consumers and producers are the first and second parties respectively, while third parties are individuals, organizations, property owners or any resources that are indirectly affected by the transactions of consumers and producers. For that matter, the statement above implies that the costs of debt contracts are highly experienced by third parties in the economy rather than the consumers and producers who are first and second parties. It has however specified the kind of an economy where that can evident, and that is an economy that is not properly priced among the private parties (Amir and Atif, 2016).
Part b: Explain how the ‘shared-responsibility mortgage’ contract mitigates the negative externality of the debt contract.
This type of mortgage mitigates the negative externalities through the ability of its principal balance and interest payments to automatically adjust downwards whenever the house prices in the neighborhood decline. In this scenario, the homeowners are the third parties since they don’t participate directly in the transactions involving mortgages. For that matter, since shared responsibility mortgages provide relief of debt contract to homeowners under difficult economic circumstances, it qualifies as a negative externality mitigating factor (Amir and Atif, 2016).
The reason as to why shared responsibility mortgage fits under the bracket of negative externality mitigating factor is because it is protecting homeowners who could have been affected by the house price fluctuations in the neighborhood despite them not being involved in the direct transactions involving houses.
Part c: The authors claim that the government tilts the field in favor of typical or standard debt contracts by making the standard debt contracts securitizable, whereas, ‘shared responsibility mortgages’are not securitized. Securitization involves carving-out risk-free assets from a pool of risky mortgages and selling them separately to investors. In Q1, you read an article that discusses “disproportionate preference for safety” among investors. Integrate the concept of “disproportionate preference for safety” with the notion of “securitization” to explain how the government tilts the field.
The government tilts the field by allowing mortgage brokers to carve out for risk-free assets from a risky mortgage pool acquired from banks and other agents only on the side of debt contracts only but closing out on the shared responsibility mortgages. This works on the ancient principal drawn from the psychology of normal human beings that entails their character of disproportionate preference for safety. In this approach, the government allows the practice of securitization being facilitated by a disproportionate preference for safety only on the side of debt contracts but not on shared responsibility mortgages. Through that, the government manages to tilt the field (Amir and Atif, 2016).
References
Howe, J., 2015. The Impact of the China-Australia Free Trade Agreement on Australian Job Opportunities, Wages, and Conditions. Report commissioned by the ETU, The University of Adelaide, Adelaide.
SA, Australia.Siddiqi, H., 2017. How our addiction to safety could lead to another financial crisis. In Conversation (Vol. 25). Conversation
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