In the country of Poorland, the only financial assets available are banking accounts. The banking sector is
Question:
In the country of Poorland, the only financial assets available are banking accounts. The banking sector is nevertheless very competitive. Banks offer savings accounts with an interest rate of 25%. They also extend lines of credit at the same rate. Currently only two are the relevant future scenarios. a) Give a definition of (competitive) financial equilibrium for Poorland. Make sure to introduce and define all the necessary elements and variables of interest. The government in Poorland introduces a bond which pays 1 taller (the local currency) tomorrow no matter what the realization of uncertainty. b) If the bond price is q2 = 0.8, does the Law of One price hold? Are there profitable arbitrage opportunities? Are financial markets complete? c) Suppose that instead q2 = 0.5. Could this be an equilibrium price in Poorland? Explain, either by invoking the relevant claim(s) seen in class, or by providing a (simple) example. d) Is the market outcome ("allocation") likely Pareto efficient? Why or why not? Be as formal as you can. e) Suppose that the two relevant scenarios represent personal risks. Give an example of such risk, and explain why it is unlikely that contracts offering full insurance against this risk become available in Poorland. [Hint: It does not have anything to do with being poor.]