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Consider a Diamond-Dybvig (1983) model, with periods 0, 1, and 2. Each member of a large population has one unit of output at time zero
Consider a Diamond-Dybvig (1983) model, with periods 0, 1, and 2. Each member of a large population has one unit of output at time zero and access to an investment project that is begun at time 0. It returns 1 unit if interrupted in period 1 and R > 1 units if left until period 2. Output can also be stored between periods. All people are identical in period 0, but in period 1 some fraction t of people will discover that they need to consume early (in period 1) while the remaining fraction can wait until period 2.The basic finding is that under the market outcome, people who discover that they need to consume early undertake the project and consume 1 unit; and people who can wait until period 2 consume R > 1 units. a) Provide an intuitive discussion on why banks can improve on this outcome. In particular, discuss the relative treatment of each type of consumer under the market outcome versus the outcome with banks (which type of consumer gets more or less than the market outcome?) b) Provide an intuitive discussion of why banks are subject to runs in the Diamond-Dybvig model. In particular, use your analysis of how banks treat people differently than the market outcome to support your
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