Consider a small region with 500 residents and only one bank called ABC Bank serving all residents. Each person has £400 to deposit at Time 0. Residents would spend their money either at Time 1 or Time 2. Assume 40% of the residents will spend their full deposit in Time 1 and the rest will withdraw at Time 2.

On behalf of its depositors, ABC bank can make the following investment choices:

Investment X: Keeping the money as cash reserve

o  Money can be withdrawn any time

o  No profit is generated, i.e., the gross rate of return is 1

 

· Investment Y: Investing the money in a project

If withdrawing at Time 1, the gross rate of return is 1

If withdrawing at Time 2, the gross rate of return is 1.4

 

a) If ABC Bank promised to pay gross return rate of 1.25 for deposit withdrawals at Time 2, calculate the minimum amount of money that ABC Bank should put in Investment Y.

b) The manager of ABC Bank plans to set the gross interest rate at 1.2 for depositors withdrawing at Time 1. Comment on his plan and use calculations to support your analysis.

 

c)  Some of the residents believe ABC Bank might go under in the future and it is better to store their money at home than depositing at ABC Bank. They also convinced their friends to withdraw money at Time 1. Analyse the impact of the sudden withdrawals and comment on their belief.