Economics 208 Macroeconomics

Marek Kapika c Spring 2011

Problem set 5
1 Bank Runs

Consider an economy with three periods t = 0, 1, 2. Individuals are endowed with one unit of the consumption good at t = 0. There are two types of assets. An investment in the liquid (short) asset yields a rate of return 1 next period. A time zero investment in the illiquid (long) assets gives a return F > 1 in t = 2. If the investment in the long asset is interrupted in period t = 1 then the return is f = 1. (Since the long asset yields the same return as the short asset when interrupted, we will assume that in period zero everything is invested in the long asset.) There are two types of agents. With probability the agent is an early type and cares only about consumption at t = 1. With probability 1 , the agent is late and cares about the sum of consumption in both periods t = 2. In the aggregate, and 1 also represent fractions of each type of consumers. The agents realize their types at the beginning of period 1. Preferences can be described be the expected utility U = ( 1 1 ) + (1 )( ). c1 c1 + c2

1. Consider rst the consumers problem in case of no banking and no markets, i.e in autarchy. What is the consumption of early and late consumers? 2. Suppose banks accept deposits at time 0 and pay c1 if you withdraw your deposits at t = 1, and c2 if you withdraw your deposits at t = 2. Solve for the equilibrium deposit contract. How does it compare to consumption from part (1)? 3. What happen if all agents want to withdraw their deposits at t = 1 and the bank operates under a sequential service constraint? Specically, let be a fraction of people that will be able to withdraw their deposits in period 1 and 1 be a fraction of people that will be left with nothing. Compute .