1. Will the problems of credit markets disappear when developing countries become more affluent? Explain your answer.

2. How does monitoring alleviate informational asymmetries and what effect does it have on loans of different sizes?

3. This is a problem on adverse selection in credit markets. The assumptions are the following. Suppose 50% of the borrowers are "safe" (meaning they invest in safe projects) and 50% of the borrowers are "risky" (meaning they invest in risky projects). The safe project gives a return of 140 with probability 100%. The risky project gives a return of 300 with probability 50% and a return of zero with probability 50%. The size of the loan is 100 and the entrepreneurs (borrowers) need to borrow the whole 100. The bank wants to break even (make zero profits). There is limited liability for borrowers.

a. Perfect information. Suppose the lender (or bank) has perfect information, which means that it can recognize which loans are safe. What is the minimum interest rate the bank should charge if the bank wants to break even? Note: I did not actually solve this problem in the lecture, but I discussed it briefly.

b. Imperfect information. Suppose the lender (bank) cannot recognize which loans are safe. The lender knows that there are two types of borrowers/projects and that 50% of the borrowers are safe and 50% of the borrowers are risky. However, the bank cannot tell if a borrower has a safe or risky project. What is the minimum interest rate the bank should charge if the bank wants to break even?

c. Imperfect information. Suppose the lender (bank) cannot recognize which loans are safe. The lender knows that there are two types of borrowers/projects and that 50% of the borrowers are safe and 50% of the borrowers are risky. However, the bank cannot tell if a borrower has a safe or risky project. Assume that at the interest rate you found in b) there is an excess demand for loans (quantity demanded > quantity supplied). What happens if the lender charges a higher interest rate? Above what interest rate would the safe borrowers stop demanding a loan?

4. This is a problem on moral hazard in credit markets. An entrepreneur has to decide between two projects, a safe project and a risky project. The safe project gives a return of 160 with probability 100%. The risky project gives a return of 300 with probability 50% and a return of zero with probability 50%. The investment required for both projects is 100. Assume risk neutrality (decisions based only on expected returns) and limited liability for the borrower.

a. Without borrowing. Suppose the entrepreneur saved a lot in the past years and he already has the capital required for the project (100). Which project will he choose without borrowing?

b. With borrowing. Suppose the entrepreneur did not save and he has to borrow the whole 100 from the bank. The interest rate is 10%. Which project will he choose with borrowing?

c. Effect of collateral. Suppose the entrepreneur did not save and he has to borrow the whole 100 from the bank. The interest rate is 10%. However, the bank now requires a collateral of 60. Which project will the entrepreneur choose with borrowing and collateral?

d. Effect of collateral. Suppose the entrepreneur did not save and he has to borrow the whole 100 from the bank. The interest rate is 10%. However, the bank now requires a collateral of 80. Which project will the entrepreneur choose with borrowing and collateral?

e. Effect of collateral. Suppose the entrepreneur did not save and he has to borrow the whole 100 from the bank. The interest rate is 10%. Find the minimum level of collateral that will lead the borrower to choose the safe project.

f. Effectofmonitoring.Supposetheentrepreneurdidnotsaveandhehastoborrowthewhole100 from the bank. The bank can monitor the borrower to make sure that he chooses the safe project. Monitoring is very effective: with monitoring, the borrower always chooses the safe project. The cost of monitoring is 50. What is the minimum interest rate the bank should charge if the bank wants to break even?

g. Effect of monitoring. Suppose the entrepreneur did not save and he has to borrow the whole 100 from the bank. The bank can monitor the borrower to make sure that he chooses the safe project. Monitoring is very effective: with monitoring, the borrower always chooses the safe project. The cost of monitoring is 30. What is the minimum interest rate the bank should charge if the bank wants to break even?

h. Effect of monitoring. Suppose the entrepreneur is considering a bigger project that requires an investment of 200. He has to borrow the whole 200 from the bank. The bank can monitor the borrower to make sure that he chooses the safe project. Monitoring is very effective: with monitoring, the borrower always chooses the safe project. The cost of monitoring is 30. What is the minimum interest rate the bank should charge if the bank wants to break even?