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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.