LIQUIDITY, SUBPRIMES AND PRUDENTIAL AND MONETARY POLICY TSE DEEQA EXAM December 19, 2008 Jean Tirole * You have three (3) hows. * Closed books. * Good lucktQuestion 1 Answer concisely and precisely 3 out of the following following, 5 questions: () Why can governments provide liquidity (Le, what is it that the governments «its do that the private sector cannot?) When is the benefit. of goverament. provision of liquidity particularly high’? (ii) Explain the Jacklin critique of the Diamtond-Dybrig model (for this, set up very briefly the Diamond-Dybvig structure). (ii) Why can there be shortages of liquidity in an open eeonovey Give an example in which there is no such shortage and one in which there is (iv) Discuss the notion of “waste of liquidity” and give examples (v) Assuming that there is no waste of liqnidity, is there enough inside liqnicity (and why?)? (Hint: distinguish between the ease of corporate net lending ad net borrowing) Question 2 (monetary bailouts) There is a mass 1 of entrepreneurs. There are three periods, ¢ = 0.1.2. The repre. sentative entrepreneur has wealth A at date and preferences over the thren periods comer + ea where ¢ is her date’ coustungption. Investment takes place at ditte 0 and exhibits coustant returns to scale. If “intact” at date 1 (see below). the investanent wields, per mit and at date 2, 2) > 1. of which 29 <1 is plodgeable to investors Each entrepreneur has at date @ the choice between two technologies: Risky teclology: With probability 1 —¢ (probability of “distress”). the investient reymires © ro-investiment of one unit per mit of initial investment at date [. With probability a, no reinvestinent is needed (the firin is “nitact”) Safe reclmology: Alternatively, the investment never requites a reinvestment al date 1, ban its initial cost is Chen A> 1 per waitOne will let f= A/(1~ 029) and i= A/(K — between dates 0 and 1 and consumers ate risk neutral and demand rate of return There is no store of vehi equal to 0. Assume that: 1 a>K “ a {i) Interpret condition (*). Show that it implies that the entrepreneurs choose the safe technology (compute the entrepreneurs’ net wility for eat: choice) (ii) Suppose that. the government can, at a social cost L(R) for consiners 1! < O. LY <0, L(1) = 0, reduce (one plus) the rate of interest front 1 to R <1 (and so entrepreneurs must return rate of return only R at date 2 on their date-1 horrewing) ‘The government's objective function at date (is LCR] +.4U. where U/ is the utility of entrepreneurs and {is the relative weight assigned to them in the social welfare function, Let x € [0,1] denote the (endogenous) fraction of entrepreneurs choosiny the risky strategy. Show that there is am equilibriuu in which the government lowers che cate rare of interest if and only if Ezy} < 20 — a}(m = po} # Conclude that, given the government's reaction, the entrepreneurs: strategies ox hibit strategic complementarities. Can this highly stylized inodel be seen as a metaphor for (soni aspects of) tee ‘ongoing cri Question 3. (liquidity premium) Cor idler an economy in which all firms are hit ar dare 1 by rhe same (per unin) Liquidity shock, which can be either ¢ (probability 1— 9) or 0 (probability a). ‘The representative firm starts with assets A and invests Fat dlate Q. Tf there is ue shock at date 1 or a shotk that is withstood, the fuvestment yields. per anit and at date 2 zy. of which = < + is pledgeable, Let # € [0.1] denote the coutimmation scale when, che fir is faced with shock ¢There are L units of stores of value in the economy. They cach yiold 1 at date | They trade at price q at date 0 The consumers demand a Zero expected rate of return (and so q > 1) (i) Letting £ denote a firm's hoarded liquidity. write the date-1 liquidity constraint (ii) Write the investinent copacity and the entrepreneur's net, utility when the firm, chooses strategies i = and i= Lrespectil ji) Show that the liquidity premium g ~ 1 cannot execed g™* — | where a q @ 14 (g@™*—1)(2-4) + (1-0) = + (iv) Show that for L below some L*, then liquidity is priced at A_1+(Q-a) g-l Question 4 (liquidity and deepening investment)° ey Enrepreneur has wealth & and Gxebsive rvestment project p iscealice. Reiavesting p rises probabilities of secess 0 p.4 & Morat Outeouve hava orth, Figure 5.14 (i) Consider the fixed-invesiment model. The ntrepreneur has cash A and can invest [> Aina roject. The project's return in the case of success espectively, failure) is R (respectively, 0). The prob: bility of success is py if the entrepreneur behaves he then gets no private benefit) and p, = Py ~ Ap she misbehaves (in which case she gets private snefit B), in this subquestion and in the subse- ent extension, one will assume that the praject viable only if the incentive scheme induces the uirepreneur to behave, ‘The entreprencur and the pital market are risk neutral; the entrepreneur is pieced by limired ability; and the market rate of ‘est is equal 10 0. Let r= puR and po = pulR ~ B/AP), Vassume pi > I> po. hat is the necessary and suificient condition for project to be financed? i) Now add an intermediate stage, in which there n option to make a deepening investment, This sstment increases the probability of success to =r Gn the case of good behavior) and my, + 7 (in se of misbehavior), Is she deepening investinent is not made, the prob abllities of success remain py) and py, respectively This deepening investment costs p, where pis un known ex ante and distributed according to distr bution F(p) and density fig! ax (0%). Fhe wming, 4s summarized in Figure 3.14. Let = T/P, Br = WM, and py ~ Ue Write the incentive compatibility constraint and {hor a given cutoff p*) the investors’ breakeven con. dition, (63) What is the optima) cutoff p*? (Tint: consider theee cases, depending on whether igi-aa soll + BFC “pS pyay. with k= 0,1) fix) Should the firm content itself with returning. 40 the capital market at date 1 in order to finanee the deepening investment {if any)?