Homework Assignment 3
Economics 333
Money and Banking
Assigned: November 3rd , 2015
Due: November 10th , 2015
1.
Organization of the Central Bank Research the organizational framework of the
bank of Japan. Link
a. Independence. What is the title of the chief executive of the Bank of Japan? How
long is the term of office? How long is the term of the Prime Minister of Japan? How
does relevant legislation support independence?
The chief executive of the BoJ is the Governor. The Governor is appointed by the
Cabinet, but must be approved by both houses of the legislature. (Bank of Japan Law,
Article 23). The Governor is appointed for a term of 5 years (BoJ Law, Article 24) while
the Prime Minister of Japan must call an election within 4 years. BoJ Law Article 3
states “The Bank of Japan's autonomy regarding currency and monetary control shall
be respected”
b. Decision-making by Committee. Identify the committee responsible for monetary
policy in Japan. How many members are there?
The Policy Board controls monetary policy (BoJ Law Article 15) and consists of 9
members including the Governor (BoJ Law Article 16).
c. Transparency and Accountability. Describe the framework for informing the public
about the monetary policy process. What channels does the Bank of Japan use. Link .
How does the legislature hold the BoJ accountable?
The Bank of Japan provides monetary policy statements and Minutes of the Monetary
policy meetings. Under the new Framework for Transparency, the BoJ will provide
enhanced forecasts of inflation and output, along with forecasts and risk assessments of
individual members of the Policy Board. The BoJ will prepare a report to the Diet every
six months and the Governor will attend a meeting of the Diet to answer questions.
2. Adverse Selection. You are an investor in the market for junk bonds (which by
custom have a face value of 100). There are a number of a number of firms that
have projects that they would like to finance. Some of these projects are risky and
some are relatively safe. Firms with risky projects are willing to sell discount
bonds to investors to finance risky projects if they can sell their bonds for at least
80. Firms with safe projects are only willing to sell their bonds to if they can get a
price of at least 90. Investors put a value on risky bonds of 75 and will offer to
buy bonds issued by risky firms at a price of 75. Investors put a value on safe
bonds of 95 and will offer to buy bonds issued by safe firms at a price of 95.
a. Perfect Information. If everyone has perfect information, then no risky
projects would be financed because the price offered by investors will be
less than the minimum price accepted by firms. What will be the average
yield to maturity on bonds?
Only the safe bonds are purchased at a price of P = 95. The yield is
100 100
1 i 

 1.053
P
95
b. Symmetric Information. Assume that no one, not even the firms
themselves, are able to distinguish between risky and safe firms. Everyone
believes that there is a 50% chance that a given firm is risky and a 50%
chance that a given firm is safe. Assume that all firms are willing to
accept the expected values of the minimum prices of safe and risky firms.
Assume that all investors are willing to offer a price equal to the expected
value of bonds. What is the yield to maturity on bonds if the price is the
price that investors are willing to offer?
The expected value of the minimum prices accepted is
E[ P]
  Pr obSAFE  PSAFE    Pr obRISKY  PRISKY 
 .5  $80, 000   .5  $90, 000   $85, 000
The expected value of the price offered is
E[ P]
  Pr obSAFE  PSAFE    Pr obRISKY  PRISKY 
 .5  $75, 000   .5  $95, 000   $85, 000
Investors offer $85000 and firms are willing to accept. The yield is 1  i 
100
 1.1765
85
c. Asymmetric information Assume that investors are not able to distinguish
between risky and safe firms. Investors look at any given firm and believe
that there is a 50% chance that firm is risky and a 50% chance that firm t
is safe. However, firms can identify with certainty whether they
themselves are risky or safe. Will any bonds be sold in this market?
If the investor was willing to offer the expected value, $85,000, then no safe firms who
know they are safe will accept. However, all risky firms would. Be willing to accept. The
investor would know, that only risky firms are in the market. But then they would be
willing to offer only $75,000. Even risky firms wont take that so no bonds are sold.
d.
Less Asymmetry Assume that an investment banker named Milken is able
to get enough information about firms so that he can identify a group of
firms which is 80% likely to be safe and only 20% likely to be risky. What
is the expected value of bonds from this group of firms to investors? Will
firms that know they are safe be willing to sell at this price?
The investor will offer
E[ P]
  Pr obSAFE  PSAFE    Pr obRISKY  PRISKY 
 .2  $75, 000   .8  $95, 000   $91, 000
Even safe firms will accept this price.
3. Moral Hazard. An entrepreneur wants to open a textile factory which costs
$100,000. You lend him $100,000 at a 10% interest rate and he promises to pay
you back $110,000 in 1 years time. If he defaults, he must pay you all the income
from the plant.
A.
The entrepreneur considers two sales plans. The first sales plan will be to
produce athletic socks. This safe investment will generate income of $130,000
with a probability of 80% and income of $120,000 with probability of 20%.
What is the expected value of income? What is the expected value of the payoff to your bond? What is the expected pay-off for the entrepreneur?
The expected value of the payoff to the sales plan is
E[ Payoff of Income]
  Pr obGOOD  PayoffGOOD    Pr obBAD  Payoff BAD 
 .8  $130, 000   .2  $120, 000   $128, 000
Under either case, the entrepreneur earns enough to pay back the bond. The
expected payoff is $110,000. In rhe good case, the entrepreneur earns the income
minus the debt repayment ($130,000-$110,000)= $20000. In the bad case, the
entrepreneur is left with only $10,000. The expected value is
 .8  $20,000  .2  $10,000   $18,000
B.
The second sales plan is to produce trendy fashions for the Japanese
market. If the plan successfully predicts a trend, it can produce large income,
but could very easily go bad. Producing trendy fashions will generate income
of $250,000 with a probability of 20% but produce only income of $50,000
with probability of 80%. What is the expected value of income? What is the
expected value of the pay-off to your bond? What is the expected pay-off for
the entrepreneur?
The expected value of the payoff to the sales plan is
E[ Payoff of Income]
  Pr obGOOD  PayoffGOOD    Pr obBAD  Payoff BAD  which is less than the cost of
 .8  $50, 000   .2  $250, 000   $90, 000
investment. There is a 20% chance that the borrower will pay the bond in full
and an 80% chance that the borrower will pay only $50,000.
E[ Payoff of Lender ]
  Pr obGOOD  PayoffGOOD    Pr obBAD  Payoff BAD 
 .8  $50, 000   .2  $110, 000   $62, 000
C.
Which project offers the greatest amount of profits at the level of society?
Which will the entrepreneur choose if they have total control of the funds and
are risk neutral? Explain the difference.
The safe project creates value while the risky project destroys value on average.
However, the risky project is preferable from the standpoint of the borrower. The
lender absorbs all of the cost of the downside while the borrower keeps all of the
benefit of the upside.
D.
Assume that the entrepreneur own an apartment which you estimate can be
resold for $30,000. Before you make the loan, you demand that he puts up this
apartment as collateral. If the entrepreneur defaults, his payoff is -$30,000 but
your payoff will be the income from the plant plus $30,000. Go back and
calculate the expected value of the pay-off to the entrepreneur and to the bond
holder under the second sales project. Would the entrepreneur invest in this
risky project if they had money at risk?
E[ Payoff of Borrower ]
  Pr obGOOD  PayoffGOOD    Pr obBAD  Payoff BAD 
 .8  $30, 000   .2  $140, 000   $4, 000
Less than the safe.