Consider an economy in which people live two-period lives in overlapping generations but are endowed only in the first period of life. Capital has a minimum size, k , which is greater than the endowment of any single individual but less than the total endowment of a single generation. Capital pays a one-period gross real rate of return equal to x = 1.2. The population grows 10 percent in each period. There exists a constant nominal stock of fiat money owned by the initial old.

(a) (5 points) In what sense is capital illiquid in this economy? Is fiat money subject to this same liquidity problem? Hint: Think about whether a single individual can use capital.

(b) (5 points) Describe an intermediary that might overcome the illiquidity of capital so that intermediated capital may be used to acquire consumption in the second period of life.

(c) (5 points) Suppose there is only one person in each generation who is able to run an intermediary. 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?

(d) (5 points) What rate of return will be offered on deposits if there are many people in each generation able to run an intermediary, such that there is perfect competition?

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