Answer Happy

1. Consider the competitive banking model of Freixas and Rochet, where banks' profit functions are given by (D, L) = (TL-r)L+(r(1 - a) - rd)D-C(D,L), where L and D are the levels of loans and deposits of a bank, rı is the rate of interest charged on loans, rp is the rate of interest paid on deposits, r is the interbank interest rate and a is the reserve requirement. Suppose that ru = 1.7, r = 1.5, rp = 1.05, a = 1 and the cost function is given by C(D,L)= D2 +L For all questions state any assumptions you are making in deriving your answers. (a) Derive banks' equilibrium level of Deposits and Loans (b) If the government increased reserve requirement, a to How would this affect banks' equilibrium level of Deposits and Loans? (c) Now consider the Competitive banking model of Freixas and Rochet where there are N identical banks with constant marginal costs of intermediation i.e. where C(D, L) = 7D+L. Suppose also that the savings and investment function are linear so that S = S, + 4Srp and I = I. - Xrl. Assume that a = 1o, Io = 10, So = 15, Bo = 10,48 = 2,41 = 4,72 = 1 and yd = 1 What are the equilibrium levels of r, rp and r_? (d) Following on from part c), if the government increased reserve requirement, a to 3. How would this affect the equilibrium level of r,rd and rı? (e) Following on from part d), how does the increase in a affect the equilibrium level of Loans and Deposits? a a