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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 '07
 Davis
 Economics, Debt

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