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0402/178.711 ALB Internal MASSEY UNIVERSITY ALBANY CAMPUS EXAMINATION FOR 178.711 MICROECONOMICS OF BANKING Semester 2 – 2004 Time allowed: THREE (3) hours All students are required to answer ANY FIVE of the NINE questions given. Questions are of equal value 1. The Monti-Klein model of a bank describes the profit function as: (rL ( L) r ) L (r (1 ) rD (D)) D C(D, L) (a) Define the first-order conditions for a profit maximum and interpret the results. (b) What will happen to rL and rD if the interest rate on the money market r increases. 2. Show that under symmetric information, optimal debt contracts are characterised by the condition: I B ( y R( y )) R( y ) , I B ( y R( y )) I L ( R( y )) when the initial problem is: max Eu B ( ~ y R( ~ y )) R (.) . s.t.Eu L ( R( ~ y )) U L0 3. Explain how collateral can be used by a lender to separate high-risk and lowrisk borrowers. 4. Explain how adverse selection and moral hazard may lead to credit rationing. 5. The Kiyotaki and Moore model of credit cycles is described in the following terms. The economy is composed of risk neutral infinitely lived agents who seek to maximise the discounted sum of their expected consumptions. There are only two goods: a nonstorable physical good used for consumption and production, and a capital good (land) used as collateral by borrowers and also as a productive asset. There are two classes of agents: entrepreneurs who own the technology and the productive asset (land), and lenders who receive endowments of the consumption good. Thus entrepreneurs have to borrow all the consumption good they invest in their projects. Show (given that borrowing possibilities are limited by capital) how productivity shocks can trigger credit cycles. 6. Explain how financial instability is caused. Outline the possible solutions to financial instability. 7. What are the risks facing a banking-firm and how can these risks be managed? 8. Do Banks need a Central Bank? 9. The Bryant Model is a 3-period economy. Each identical consumer is endowed with one unit of a good at t=0. At t=1 the consumer learns whether they must consume early (t=1) or late (t=2). Their ex-ante expected utility is given by the following function: U 1u(C11 ) 2u(C22 ) where π1 (respectively π2) is the probability of consuming early (respectively late) and δ is the discount factor. (a) Define the consumption levels in autarky. (b) Show that if trade in a risk-less bond occurred, the consumption levels would be C1=1 and C2=R. Let p be the price of the bond. (c) Define the optimal allocation given: C L 1u (C1 ) 2u (C2 ) 1 1C1 2 2 R (d) Explain why (given C u (C ) is decreasing) that financial intermediation can improve the market allocation.