WORKSHOP 8: ANSWERS

Question 1

1. (a)
An explanation of the following consumption allocations is required:
1 − C1 A
C1 A = 1 − I A + I A L  I A =
1− L
 1 − C1 A 
C2 A = 1 − I A + I A R  C2 A = 1 + ( R − 1)  
 1− L 

The maximisation conditions are the same as the conditions that are derived in the lecture slides as
we are using the same utility function:

1 + (1 − L) /( R − 1) 1 + (1 − (2 / 3)) /(2 − 1)
C1*A = =  C1*A = 4 / 5
1 +  (1 −  ) /  1 + (2 / 3)(1 − (1/ 2)) /(1/ 2)

(1 −  ) ( R − 1) * (1 − (1/ 2)) (2 − 1)
C2*A =  C1A = (2 / 3) (4 / 5)  C2*A = 8 / 5
 (1 − L) (1/ 2) (1 − (2 / 3))
1 − C1 A 1 − (4 / 5)
*
I A* = = = 3/ 5
1− L 1 − (2 / 3)

An explanation of the following consumption allocations is required:

C1M = 1 − I M + I M 
1− I M 
C2 M =  + IM R
  
where  = 1 in equilibrium and I M * = 1 −  . Derivation of  * = 1 is required.
*

Hence, the equilibrium consumption allocations:

C1*M = 1
C2*M = R = 2 , and
I M * = 1/ 2

(b)
An explanation of the following consumption allocations is required:
 C1 = 1 − I  I = 1 −  C1
R
(1 −  )C2 = IR  C2 = (1 −  C1 )
1−

The maximisation conditions are the same as the conditions that are derived in the lecture slides as
we are using the same utility function:
1
 1 1
C1* = =  C1* = 6 / 5
 +  (1 −  ) 1/ 2 + (2 / 3)(1 − (1/ 2))

C2* =  RC1* = (2 / 3)2(6 / 5)  C2* = 8 / 5

I * = 1 −  C1* = 1 − (1/ 2)6 / 5 = 2 / 5

(c)
 1 − C1 A 
Budget constraint in Autarky: C2 A = 1 + ( R − 1)  ; vertical intercept = 4
 1− L 
horizontal intercept = 4/3

R
Budget constraint with Intermediation: C2 = (1 −  C1 ) ; vertical intercept = 4
1−
horizontal intercept = 2

Note that the market equilibrium allocation satisfies bank’s budget constraint; hence, it is located on
the budget line.

Agents’ expected utility in Autarky:

U (C1*A , C2*A ) =  ln C1*A +  (1 −  ) ln C2* A = 1/ 2 ln(4 / 5) + 2 / 3(1 − 1/ 2) ln(8 / 5)  0.045

Agents’ expected utility with a deposit contract:

U (C1* , C2* ) =  ln C1* +  (1 −  ) ln C2* = 1/ 2 ln(6 / 5) + 2 / 3(1 − 1/ 2) ln(8 / 5)  0.248

Agents’ expected utility in the presence of a secondary market:

U (C1*M , C2*M ) =  ln C1*M +  (1 −  ) ln C2*M = 1/ 2 ln1 + 2 / 3(1 − 1/ 2) ln 2  0.231

2
 Since the bank is assumed to know the
probability of being type 1, and therefore by the
law of large numbers, the total number of type 1
agents, it can attain the full-information
allocation by investing the optimal amount of
the homogeneous good in the available
technologies. Hence, as the costly early
liquidation of the long-term investment is
avoided in comparison to the Autarky case, the
feasible allocations as indicated by the bank’s
budget set incorporates the allocations
attainable under Autarky.

Deposit contract’s allocation Pareto-dominates

the autarky allocation as it offers liquidity
insurance to risk-averse depositors; insurance
against the unlucky event of turning out to be
Type 1 (i.e. C1 A  1  C1* and C2* = C2 A  R ).
Agents can achieve a higher level of expected
utility as indicated on the diagram since the
allocation that can be attained with a deposit
contract lies on a higher indifference curve in
relation to the Autarky allocation.

(d)
As discussed in the lecture slides. It will be desirable to derive and explain the game matrix, the
associated payoffs, and the two Nash pure-strategy equilibria: Bank Run (Withdraw, Withdraw) and
Optimal allocation (Wait, Wait).

Representative Type 2
Withdraw Wait
All other Type 2 Withdraw EP, EP EP,0
Wait C2* , C1* C2* , C2*
where EP = [(π C1*+(1- π C1*)L)/ C1*] C1*  1. Explanation of expected payoff EP is required.

3
2. (a)

An explanation of the following consumption allocations is required:

1 − C1 A
C1 A = 1 − I A + I A L  I A =
1− L
 1 − C1 A 
C2 A = 1 − I A + I A R  C2 A = 1 + ( R − 1)  
 1− L 

Maximisation problem:
max  C1A +  (1 −  ) C2 A
{C1 A ,C2 A }

 1 − C1 A 
subject to: C2 A − 1 − ( R − 1)  
 1− L 

  1 − C1 A  
Lagrangian function:  =  C1 A + p (1 −  ) C2 A −   C2 A − 1 − ( R − 1)  
  1− L 
   R −1 
= − =0
C1 A 2 C1 A  1− L    (1 −  )  R − 1  
2

 C2 A = C1 A   

=
 (1 −  )
− = 0    1 − L 
C2 A 2 C2 A

  1 − C1 A 
= C2 A − 1 − ( R − 1)  =0
  1− L 

1− L 1− 2 / 3
1+ 1+
 C1*A = R −1 = 3 −1  C1*A = 7 / 22
  (1 −  )   R − 1   2 / 3(1 − 1/ 2)   3 − 1 
2 2

    1 − L  + 1  1/ 2
   +1
  1− 2 / 3 
2 2
  (1 −  )  R − 1    2 / 3(1 − 1/ 2)  3 − 1  
C =C 
* *
   = 7 / 22      C2 A = 56 /11
*

   1 − L   1 − 2 / 3 
2A 1A
 1/ 2
1 − C1 A 1 − (7 / 22)
*
I A* = =  I A* = 45 / 22 .
1− L 1 − (2 / 3)

BE CAREFUL, 0  I  1 so the computed equilibrium value is not feasible. Since the maximum value
that I can take is 1, the equilibrium allocation in Autarky is:

C1*A = L = 2 / 3
C2* A = R = 3
I M* = 1

Allocations that satisfy the budget constraint equation but lie above the allocation ( C1*A = 2 / 3 ,
C2* A = 3 ) violate the condition 0  I  1 and, therefore are not feasible.
4
(b)
An explanation of the following consumption allocations is required:
 C1 = 1 − I  I = 1 −  C1
R
(1 −  )C2 = IR  C2 = (1 −  C1 )
1−

Maximisation problem:
max  C1 +  (1 −  ) C2
{C1 A ,C2 A }

R
subject to: C2 = (1 −  C1 )
1− 

 R 
Lagrangian function:  =  C1 + p (1 −  ) C2 −   C2 − (1 −  C1 ) 
 1− 
   R 
= − =0
C1 2 C1 1−  
 C2 = C1   R 
2

  (1 −  )
= − = 0
C2 2 C2

 R
= C2 − (1 −  C1 ) = 0
 1−

1 1
 C1* = =  C1* = 6 / 7
 +  (1 −  ) R 1/ 2 + (2 / 3) *1/ 2 * 3
2 2

C2* = C1*   R  = 6 / 7  2 / 3* 3  C2* = 24 / 7

2 2

I * = 1 −  C1* = 1 − (1/ 2)6 / 7 = 4 / 7 .

(c)

An explanation of the following consumption allocations is required:

C1M = 1 − I M + I M 
1− I M 
C2 M =  + IM R
  
where  = 1 in equilibrium and I M * = 1 −  . Derivation of  * = 1 is required.
*

Hence, the equilibrium consumption allocations:

C1*M = 1
C2*M = R = 3 , and
I M * = 1/ 2
5
  1 − C1 A 
Budget constraint in Autarky: C2 A = 1 + ( R − 1)  ; vertical intercept = 7
 1− L 
horizontal intercept = 7/6
R
Budget constraint of a Bank: C2 = (1 −  C1 ) ; vertical intercept = 6
1−
horizontal intercept = 2

Note that the market equilibrium allocation satisfies bank’s budget constraint; hence, it is located on
the budget line.

Agents’ expected utility in Autarky:

U (C1*A , C2*A ) =  C1*A +  (1 −  ) C2*A = 1/ 2 2 / 3 + 2 / 3(1 − 1/ 2) 3  0.985

Agents’ expected utility with a deposit contract:

U (C1* , C2* ) =  C1* +  (1 −  ) C2* = 1/ 2 6 / 7 + 2 / 3(1 − 1/ 2) 24 / 7  1.08

Agents’ expected utility in the presence of a secondary market:

U (C1*M , C2*M ) =  C1*M +  (1 −  ) C2*M = 1/ 2 1 + 2 / 3(1 − 1/ 2) 3  1.077

The market allocation dominates

the Autarky allocation as it avoids
the cost of early liquidation of the
long-term investment; agents can
trade their claims in long-term
investment in period 1.

Deposit contract’s allocation

Pareto-dominates the market
allocation as it lies on a higher
indifference curve.

6
Numerical Solutions to Exam Paper 2018/19

Similar to Question 2 for a utility function of the form 𝑈(𝐶) = √𝐶, where 𝑅 = 4, 𝐿 = 1/3, 𝜋 = 1/3,
𝜌 = 1/3

∗ ∗
Autarky solution: 𝐶1𝐴 ≈ 0.41, 𝐶2𝐴 ≈ 3.67 𝑎𝑛𝑑 𝐼𝐴∗ ≈ 0.89

∗ ∗
Intermediated solution: 𝐶1𝐵 ≈ 1.59, 𝐶2𝐵 ≈ 2.82 𝑎𝑛𝑑 𝐼𝐵∗ ≈ 0.47

Expected Utility: 𝐸𝑈𝐴 ≈ 0.64, 𝐸𝑈𝑀 ≈ 0.78, 𝐸𝑈𝐵 ≈ 0.79

Numerical Solutions to Exam Paper 2017/18

Similar to Question 2 for a utility function of the form 𝑈(𝐶) = √𝐶, where 𝑅 = 6, 𝐿 = 2/3 𝜋 = 0.7,
𝜌 = 1/3

∗ ∗
Autarky solution: 𝐶1𝐴 ≈ 0.82 , 𝐶2𝐴 ≈ 3.75 𝑎𝑛𝑑 𝐼𝐴∗ ≈ 0.55

∗ ∗
Intermediated solution: 𝐶1𝐵 ≈ 1.11, 𝐶2𝐵 ≈ 4.44 𝑎𝑛𝑑 𝐼𝐵∗ ≈ 0.22

Expected Utility: 𝐸𝑈𝐴 ≈ 0.827, 𝐸𝑈𝑀 ≈ 0.945, 𝐸𝑈𝐵 ≈ 0.948

Numerical Solutions to Exam Paper 2016/17

Similar to Question 1 for a utility function of the form 𝑈(𝐶) = 𝑙𝑛𝐶, where 𝑅 = 4, 𝐿 = 1/3, 𝜋 = 1/3,
𝜌 = 1/3

∗ ∗
Autarky solution: 𝐶1𝐴 ≈ 0.733 , 𝐶2𝐴 ≈ 2.2 𝑎𝑛𝑑 𝐼𝐴∗ ≈ 0.4

∗ ∗
Intermediated solution: 𝐶1𝐵 ≈ 1.8, 𝐶2𝐵 ≈ 2.4 𝑎𝑛𝑑 𝐼𝐵∗ ≈ 0.4

Expected Utility: 𝐸𝑈𝐴 ≈ 0.0718, 𝐸𝑈𝑀 ≈ 0.308, 𝐸𝑈𝐵 ≈ 0.39

Question 2

Answer the following Multiple Choice Questions:

1. B
2. D
3. D