10. Financial Market Equilibrium

Question 1

What is r?

Answer 1

Real rate of interest

Question 2

What is the saving function?

Answer 2

S(r) where S’(r)>0

Question 3

What can we say about U(c0,c1)?

Answer 3

U(c0, c1)= u(c0) + c1, where u(.) is increasing and concave

Question 4

What does the functional form of the savings function (supply of funds by households) do?

Answer 4

It preserves risk neutrality wrt returns while making the savings function perfectly elastic

Question 5

What is the maximisation problem and solution to the savings function?

Answer 5

Max(u(c0) +c1)
Subject to
c0+ c1/(1+r)=y

Solution
u’(c0(r))=1+r

Question 6

Why is period-0 consumption decreasing in r and hence savings S(r)=y-c0(r) increase in r?

Answer 6

Because u is concave

Question 7

For the balance sheet channel: moral hazard, what assumptions do we make?

Answer 7

-continuum of risk neutral entrepreneurs
-fixed investment model
-Heterogeneity in A: cumulative distribution function G(A), density function g(A), support [A, Ā] where Ā<=I
-pHR>(1+r)I>pLR+B

Question 8

What is a necessary and sufficient condition for an entrepreneur with assets A to receive financing in the balance sheet channel: moral hazard?

Answer 8

PH(R-B/delta p)>= (1+r)(I-A)

Question 9

How do we define A*(r)?

Answer 9

Such that

PH(R-B/delta p)= (1+r)(I-A*(r))

Question 10

What is the net demand for funds by investors given by?

Answer 10

I(r)= (1-G(A*(r)))I-A^e

Question 11

What is true at market clearing?

Answer 11

I(r)=S(r)

Question 12

What happens if the distribution of A shifts to the left?

Answer 12

Then the demand for funds will increase for those firms that can still obtain funds. But the proportion of firms that can obtain funds decreases

Question 13

What assumptions do we make in the balance sheet channel: adverse selection model?

Answer 13

-Asymmetric info about private benefits.
-All borrowers have the same fixed investment technology and the same level of assets A<I
-heterogeneity: private benefit B is distributed on the interval [0,B top] according to the cumulative distribution function H(B); private info

Question 14

What are the only feasible contracts in the balance sheet channel: adverse selection and why?

Answer 14

Pooling contracts. All borrowers make the same repayment R-Rb. Bad types (high B) can’t be screened out since their surplus from the lending relationship is higher to that of the entrepreneur with lower private benefits

Question 15

When does the entrepreneur behave and misbehave?

Answer 15

Behaves if B<B(Rb)
Misbehaves if B>B(Rb)
Where (delta p)Rb= B*(Rb)

Question 16

What does the cut off level of benefits depend on?

Answer 16

It’s endogenous and depends on the level of repayment

Question 17

What is the lenders break even condition given by?

Answer 17

P hat(Rb)(R-Rb)=(1+r)(I-A)

Question 18

What is the expected probability of success from a lenders perspective?

Answer 18

P hat(Rb)= pH x H(B(Rb))+ pL(1-H(B(R)))

Question 19

What happens if the debt burden increases for a given p hat?

Answer 19

Rb decreases, and the entrepreneur is less likely to behave (B* decreases). As a result p hat decreases which in turn increases the debt burden

Question 20

What does the lending channel focus on?

Answer 20

The impact of the strength of financial intermediaries’ balance sheets on firm’s activity. Weak firms depend on monitoring and certification by financial intermediaries to secure access to funds

Question 21

What are the extensions to the fixed investment model added in the lending channel?

Answer 21

-heterogeneity in R and A
-three types of agents: Investors, Entrepreneurs and monitors
-monitors charge interest rate X>1+r and ensure the entrepreneur exerts effort (prob of success is pH)
-borrower can receive funds either from investors or monitors

Question 22

Three possible equilibria in lending channel model

Answer 22

1. If pH(R-B/delta p) >= (1+r)(I-A) the entrepreneur borrows from investors
2. If pH(R-B/delta p)= (1+r)(I-A) and pHR>X(I-A) the entrepreneur borrows from monitors
3. If pH(R-B/delta p) <(1+r)(I-A) and pHR < X(I-A) the entrepreneur can’t borrow

Question 23

What are the three possible causes of economic slowdown we find?

Answer 23

1. Decrease in savings (lower secular growth- neoclassical model)
2. Decrease in average A: industrial recession (balance sheet channel)
3. Decrease in bank funds: credit crunch