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Spring 2014

Problem Set 1

Due Thursday, February 20th, 2014 in class.

1 Catalytic Finance

In this exercise we expand the usual framework of a currency crisis to study the behavior of three types of agents:

private-sector agents, the domestic government, and the IMF. The goal is to analyze how external assistance

can sometimes enhance the incentive for governments to take costly adjustment eort, yet at other times it may

result in a standard moral hazard problem.

Setup. There is a measure one continuum of private-sector agents, indexed by i [0, 1]. Each agent i chooses

whether or not to attack a currency a

i

0, 1

a

i

=

0 if not attack

1 if attack

Let denote the mass of agents attacking.

=

Z

a

i

di

The regime can either change 1 = 1, or not change 1 = 0. A regime change in this game is the devaluation

of the currency. Devaluation occurs (1 = 1) if and only if

0 + : + c

Otherwise, there is no regime change, 1 = 0. Here 0 R represents the exogenous underlying economic

fundamentals of the country, : is assistance by the IMF, and c is adjustment eort taken by the domestic

government.

Note that both : and c increase the region of no devaluation, but this will come at a cost. Finally, we say

the regime is viable when 0 + c _ 0.

Payos. Here we describe the payos for (i) the private-sector agents, (ii) the government, and (iii) the IMF.

(i) Agents who attack get payo 1 c. Agents who do not attack get payo

(0, :, ) =

0 if 0 + : + c

1 if _ 0 + : + c

Thus, the payos of an agent may be written as

1 = 1 1 = 0

a

i

= 1 1 c 1 c

a

i

= 0 0 1

1

(ii) The governments payos are given by

(0, :, ) (c)

Thus, there is a cost of adjustment eort.

(iii) The payos for the IMF are given by

): if 0 + c < 0

(0, :, ) ): if 0 + c _ 0

Timing.

1. Nature draws c. This parameter is then common knowledge.

2. The government chooses c. This parameter is then common knowledge.

3. The IMF chooses :. This parameter is then common knowledge.

4. Nature draws 0 ~ A(c, 1,c). This is unobservable.

5. Each agent observes a private signal about 0 given by

r

i

= 0 +

i

with

i

~ A(0, 1,,), i.i.d.

Questions.

(a) Show that for strategic purposes, the agents payo matrix is equivalent to the usual one.

1 = 1 1 = 0

a

i

= 1 1 c c

a

i

= 0 0 0

(b) Given :, c and c, characterize the equilibrium in the last stage of the game. Let r

(c) , 0

threshold functions of this equilibrium.

(c) Show that the condition

c

_

,

_

_

2

is sucient for uniqueness of the equilibrium in the last stage subgame. From now on assume that this

condition holds.

(d) Assume , and solve for 0

. How does 0

depend on : and on c?

(e) Given c, c and the equilibrium in the last stage, state the maximization problem faced by the IMF.

(f) Show that if we assume ) small and take c , the approximate solution is

:

(j) -

8

<

:

0 if j < 0

(1 c) j if 0 _ j _ 1 c

0 if j 1 c

where j = c + c.

2

(g) Given c and your previous answers, state the governments problem in the rst stage. Assume (c) = c

2

.

Solve for the optimal eort choice c as a function of c.

(h) Solve for the optimal choice of eort c as a function of c in a world without IMF assistance (i.e. : = 0).

Compare your answer to part (g). Can adjustment eort be ranked unambiguously across the two regimes?

Interpret your results.

(i) Now assume that the IMF can commit on a function :(c, c). Solve for the IMFs optimal function and

for the governments optimal choice of eort under this commitment. Interpret your results.

(j) Assume (c, :) could be chosen in a centralized way to maximize a weighted average of the payos of the

IMF and the government. Assume weights 1,2 for each and solve for the optimal c and :. Interpret your

results.

3

2 Typicality of Beliefs

There is a measure one continuum of agents, indexed by i [0, 1]. Each agent i chooses whether or not to

invest, a

i

0, 1. Payos are given by

n(a

i

, ) = a

i

(0 + )

where denotes aggregate investment,

=

Z

a

i

di

and 0 is a random variable with support on the real line.

Questions.

(a) Assume 0 is common knowledge and solve for the equilibrium/equilibria.

(b) Now assume 0 is an unknown random variable. Agents observe a private signal r

i

about 0. The agents

system of beliefs is such that for all r

i

E[ 0[ r

i

] = r

i

and for any r

j

,

Pr [ r

j

< r

i

[ r

i

] = Pr [ r

j

r

i

[ r

i

] =

1

2

We interpret this as each agent believes he is typical. Solve for the equilibrium and prove uniqueness.

(c) Now assume the usual Morris Shin system of private and public signals. 0 is an unknown random variable

drawn from an improper uniform over the real line. Each agent observes a private signal

r

i

= 0 + i

i

with i

i

~ A(0, 1,c), i.i.d.

and a exogenous public signal

. = 0 + - with - ~ A(0, 1,,)

Compute the probabilities Pr [ r

j

< r

i

[ r

i

] and Pr [ r

j

r

i

[ r

i

] for arbitrary precisions.

(d) Show that the two probabilities Pr [ r

j

< r

i

[ r

i

] and Pr [ r

j

r

i

[ r

i

] found in part (c) converges to 1,2 for

any (r

i

, .) when the precision of private information goes to innity; that is, c . That is, we generate

typicality of beliefs. Relate this to the uniqueness result found in part (b).

(e) Finally, assume 0 is an unknown random variable and agents observe a private signal r

i

. The agents

system of beliefs is such that for all r

i

E[ 0[ r

i

] = r

i

and for any r

j

,

Pr [ r

j

= r

i

[ r

i

] = `

Pr [ r

j

< r

i

[ r

i

] = Pr [ r

j

r

i

[ r

i

] =

1

2

(1 `)

Show that you can construct two threshold equilibria: one with

r

= `

1

2

(1 `)

and the other with

r

=

1

2

(1 `)

What happens when ` 0? What happens when ` 1? Interpret your results.

4

3 Can better public information crowd out learning?

There is a measure one continuum of agents, indexed by i [0, 1]. There are two stages. An agent i chooses

actions a

1i

in stage 1, and a

2i

in stage 2. His payos are given by

l (a

1i

, a

2i

, a

1

) = (1 r) (a

1i

0)

2

r (a

1i

a

1

)

2

(a

2i

0)

2

where 0 is the underlying fundamental and a

1

=

R

a

1i

d, is the average action in stage 1.

The timing is as follows. First, Nature draws 0 from an (improper) uniform over the real line. In stage 1,

agents observe an exogenous private signal

r

i

= 0 + i

i

with i

i

~ A(0, 1,i

x

) i.i.d.

and an exogenous public signal

j = 0 + - with - ~ A(0, 1,i

y

)

Once agents observe their signals, they choose their actions a

1i

.

In stage 2, agents observe an endogenous public signal about the average action in stage 1

. = a

1

+ n with n ~ A(0, 1,i

u

)

Once agents observe this signal, they choose their action a

2i

.

Thus, the information set of agent i when he chooses a

1i

is .

1i

= r

i

, j, and the information set of agent i

when he chooses a

2i

is .

2i

= r

i

, j, ..

Questions.

(a) Write down the best-response function for a

1i

and solve for the equilibrium in stage 1.

(b) Given your answer to part (a), show that in stage 2, the endogenous public signal . can be transformed

by agents into an unbiased signal of 0

.

0

= 0 + c

0

n

for some c

0

.

(c) Let = c

0

n. Then .

0

= 0+ with ~ A(0, 1,i

z

). Thus, we let i

z

denote the precision of the transformed

signal .

0

. Find i

z

in terms of i

x

, i

y

, i

u

.

(d) Is i

z

increasing or decreasing in i

y

? Is i

z

increasing or decreasing in r? Interpret these results.

(e) Finally, write down the best-response function for a

2i

and solve for the equilibrium in stage 2.

5

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