Money & Banking

Money & Banking
Money and Banking 1

1. Chef X wants to start a restaurant in Exeter, and asks local bank Y for a loan of £40. X has no liquid assets and is risk neutral. X and Y cannot agree on the type and name of the restaurant. X wants to start a fancy sea food restaurant and call it Exeter Fish.
In case of the fish restaurant, X earns £80 with probability 2/3 and £38 with probability with 1/3.And Y gets £60 with probability 2/3 and £0 with probability with 1/3. While Y wants to open a restaurant specializing in sandwiches called McExe. If McExe opens then Y gets £60 and X gets £40.
a. If you are the social planner who wants to maximize the social welfare, who should get to decide the type and the name of the restaurant? If the probability of success of the fish restaurant is 1/3 and the probability of failure is 2/3 what would you recommend? (30 points)
b. Now assume that there is a third option to start a Sushi restaurant, X and Y may consider. This gives X £55 and Y £55. Discuss what kind of restaurant you would recommend and who should own the restaurant? (10 points)
2. Here is the following extension of the three date Diamond-Dybvig model: agents can invest in following three possible technologies
– a short-term investment at date 0, that yields a return r1 =1 at date 1.
– a long term investment at date 0, that yields a return R > 1 as of date 2 but can also be liquidated at date 1 for a return L < 1:
– a short-term investment at date 1, that yields a return r2 at date 2. However, r2 is observed only at date 1.
It is assumed that :1< r2Note the consumption profile (C1;C2) will depend on r2; as depending on r2 agents may choose to invest in the short-term investment in date 1.
a.Describe and discuss how consumption planning C1 and C2 may change in comparison with the standard Diamond-Dybvig model without the short-investment available at date 1. (20 points)
b.The short-term investment opportunity with r2; means that the agents are exposed to interest rate risk. Discuss, why, if r2 is low, the agents will not invest in date 1 in the short-term investment, and will not be exposed to any interest rate risk. (20 points)
c. Now assume that all the agents deposit their endowments to form a bank. The bank has the same three investment technologies described above. Discuss if the exposure to interest rate risk of r2 increases or decreases the stability of the bank. (20 points)

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