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ps2 - ECON 3310 Money and Credit Problem Set 2 Instructor...

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ECON 3310: Money and Credit Problem Set 2 Instructor: Karel Mertens Due in class on Friday October 23 1. The figure below shows the total reserves (billions of dollars) of US banks since 2000. Discuss why reserves have increased so dramatically since late 2008. 2. A firm seeks to finance an investment project of size normalized to one. The riskless rate of interest is assumed to be zero. Once a firm get its financing, it can choose between safe and risky strategy. The safe strategy produces S with probability π S and 0 with probability 1 - π S . Similarly, the risky strategy produces R with π R and 0 otherwise. Assume that only the safe strategy has a positive (expected) Net Present Value and that the pay off using risky strategy is greater than using safe one once it succeeds, i.e. π S S > 1 > π R R and R > S . Whether a strategy was successful is 1
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assumed to be verifiable by outsiders, but the strategy used is not. Because lenders cannot observe the the firm’s production, it is natural that lenders demand a fixed
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