Question

Illiquid capital and financial intermediation.(6pts) Consider an environment in which individuals live for two periods in overlapping generations and are endowed with y only in the first period. The population Nt grows by 10% each period. Capital has a minimum size k∗ such that y < k∗ < N1y, where N1 is the population in the initial period. Moreover, capital has a one-period rate of return x, and there is a constant stock of fiat money owned by the initial old.
(a) (2pts) In what sense is capital illiquid in this economy? Is fiat money subject to the same liquidity problem?
(b) (2pts) Describe how an intermediary can overcome the illiquidity of capital so that intermediated capital can be used to acquire consumption in the second period of life.
(c) (1pts) Suppose there is only one person each generation who can run an inter- mediary. What is the minimum rate of return that person must offer to attract depositors? For what values of x can this person make a profit?(Hint: rate of return must be at least as high as that of fiat money)
(d) (1pts) What rate of return is offered on deposits if there is no entry cost to becoming an intermediary (i.e. perfect competition)?

Answer 1

Fiat money:

Money which has no intrinsic value but has exchange value because it is generally accepted. Originally money was accepted by users because it consisted of materials which were themselves valuable such as gold or silver In present day money consists of paper notes with negligible intrinsic value or of book or computer entries. So modem money is fiat money.

a)

The capital size of K is larger than everyone's endowment but smaller than single generations total endowment implies that each individual, without any lending form others is unable to switch her endowment for the capital. This means capital is illiquid. Fiat money, on the other hand, is liquid because fiat money is exchanged more often than capital. In other words, fiat money is held for longer term.

b)

A bank can accept deposits from the young and invest all of the deposits into capital. Since the sum of the deposits will be greater than K', the capital will eam x next period. Hence the bank can pay back to the old with these capital earnings, and the old can consume.

c)

It is assumed here that bank offers an interest rate which is least equal to the fiat money that the people own. Hence, depositors will be willing to open savings account. The bank may be able to make profit then the capital's rate of return must greater than interest rate presented by the bank for the savings account. That is X > r must be true.

d)

If it is perfectly competitive market that the bank is operating then profits made will zero This happens when then the capital's rate of return is equal to the rate of return on interest rate for the savings account. That is, r = x