ECON0001 Week 7

Week 7
Asset market and banking system
Allen and Gale Ch 3.1-3.4

Exchange markets
Open a market at t=1, after the uncertainty disappears
Exchange one unit of a long asset, and exchange for P unit of short asset (P is the exchange rate)



Earlyconsumer I Lateconsumer
7 Lateconsumer
X
longassetK longasset x
In snortasset
son
snortassety
y

g aw

QUINN

Eachconsumer max.hucilell
tluled s.t.sctyel
ceytBcczeRx
RYlciicz Oex.y
ay equPsatisfies15
Giveneachconsumer's

17117 5 1 PI
PROOFBYCONTRADICTION
• P<1, investing in long asset is dominated regardless of it early or late consumer —> x=0, y=1, so
S≠ D
◦ Early consumers’ strategies
‣ Buy short asset at t=0 —> return =1 dominant
‣ Buy long asset at t=0, short asset at t=1—> return =P
◦ Late consumers strategies
‣ Buy short asset at t=0, repurchase short at t=1 —> return =1
‣ Buy short asset at t=0, long at t=1 —> return =R/P dominant
‣ Buy long at t=0 and keep until t=2 —> return =R
‣ Buy long set at t=0, buy short asset at t=2 —> retuned=P
• P>1 —> x=1, y=0
◦ Early consumers’ strategies
‣ Buy short asset at t=0 —> return =1
‣ Buy long asset at t=0, short asset at t=1—> return =Pdominant
◦ Late consumers strategies
‣ Buy short asset at t=0, repurchase short at t=1 —> return =1
‣ Buy short asset at t=0, long at t=1 —> return =R/P
‣ Buy long at t=0 and keep until t=2 —> return =R dominantifRP