Question

35) When interest rates in the bond market rise, A) adverse selection problems increase. C) moral hazard problems are mitigated. Answer: A Diff: 2 Page Ref: 260 B) adverse selection problems are mitigated. D) moral hazard problems increase.

Answer 1

Option A) Adverse selection problems increase: The problem of adverse selection arises due to asymmetry in information. In the case of the bond markets, when interest rates are higher two things happen - First, genuine borrowers find it hard to borrow money because of high rates of interest and thus the pool of good borrowers might shrink; second, bad borrowers are ready to borrow money at even these high rates of interest because they anyway do not plan on returning the money and their chances of default are very high. Thus with high rates of interest, the problem of adverse selection is compounded as the pool of good borrowers shrinks and it is increasingly more likely that the borrower you choose to lend to, might default (as there are higher chances of lending to risky/bad borrowers).