Question

a) Name and explain the two roles banks play in the economy

Use the following information to answer parts 4b, 4c, and 4d: Consider an economy with a large number of restaurants. The restauranteur lacks the funds to start the restaurant. There is an equal number of investors who have the funds but no desire run a restaurant, say 2 trillion investors. Each investor has 10 goods to invest. Each restauranteur requires 20 goods. Assume that 20% of the restaurants fail and return zero goods to the investor and the remaining 80% return 40 goods. The monitoring cost is 10 good per failed project.

b) Compute the expected total return for each investor

c) Compute the expected return for each investor when there are competitive banks that operate without any costs

d) compare the outcomes of part (b) to that of part (c)

Answer 1

a) Banks play two major, roles in the economy.

i) They provide loans: This increases the supply of money which in turn allows consumption to occur and businesses to expand. People get more cash and thus do more economic transactions. More transactions means more earnings for businesses and as a result greater development og GDP. Also, business grows by money spent in expanding capacity.

ii) They take deposits and act as the mediator between those who has excess money and those who require money: Those who have more money can deposit their money with the bank. This money can be lent out to those who need money. They repay the bank at some interest. Banks repay the depositors with some lesser interest as the banks keep a margin for its service.

b) Probability of Profit = 0.8

Probability of Failing = 0.2

Profitable restaurants ROI = 100%

So for every investor, return = 20 goods. Investment = 10 goods

Return from Profitable Restaurant = 0.8 * 20

Return from Failed Restaurant = 0.2 * 0

Cost of failed investment = 0.2 * 10

Initial Investment = 1 * 10

Expected Return = 0.8 * 20 + 0.2 * 0 - 0.2 * 10 = 16 - 2 = 14 goods

For every investor, expected profit = 0.8 * 20 + 0.2 * 0 - 0.2 * 10 - 10 = 16 - 2 - 10 = 4goods

c) When there are competitive banks that operate without any cost, there is more competition among the investors and banks. However, to the restauranteur, there is no difference. All investors are equal in its eyes.

So since there are 20 trillion investors and competitive banks, it is already a perfect competition. So these investors will not have any difference in expected return.

However, the banks will have a different expected rate of return where there is no cost to the bank.

So for the bank expected profit = 0.8 * 20 + 0.2 * 0 - 10 = 16 - 10 = 6goods

d) The banks will have a higher expected return of 16 goods and profitability of 6 goods while the investors will continue to have an expected return of 14 goods and profitability of 4 goods.