Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

Please explain the question in detail to make it easier to understand. Thank you! Asymmetric Information Consider a perfectly competitive credit market in which a

Please explain the question in detail to make it easier to understand. Thank you!

image text in transcribed
Asymmetric Information Consider a perfectly competitive credit market in which a commercial bank makes loans to two types of borrowers: A and B. Both types of borrowers take the loan to start some new business. Type A borrower runs a low risk business that generates a gross return of 2 when succeeded with probability 0.8, and a gross return of 0 when failed with probability 0.2. Type B borrower runs a high risk business that generates a gross return of 15 when succeeded with probability 0.1, and a gross return of 0 when failed with probability 0.9. Both types of borrowers repay their loans if the business succeeds, in which case the bank receives loan amount plus interests, and default (without getting punished) on the loan if the business fails, in which case the bank receives nothing back. Finally, the probability that bank gets either type of borrower is 0.5. 1. Suppose the bank has perfect information on the borrower type, i.e., the bank is able to distinguish two types of borrower, what would be the gross interest rate R (one plus interest rate r) that the bank charges on each type of borrower? Assume the opportunity cost of bank's funds is the (gross) riskfree rate, which is equal to 1. 2. Suppose there is information asymmetry between borrowers and the bank, Le., the bank is unable to distinguish two types of borrowers, what would be the interest rate r that the bank charges to all borrowers? 3. Continue with information asymmetry case, given the uniform interest rate that you just calculated, would each type of borrower still want to borrow in the first place? Show your calculation

Step by Step Solution

There are 3 Steps involved in it

Step: 1

blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image_2

Step: 3

blur-text-image_3

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Energy, Foresight And Strategy

Authors: Thomas J Sargent

1st Edition

1317329686, 9781317329688

More Books

Students also viewed these Economics questions

Question

Always have the dignity of the other or others as a backdrop.

Answered: 1 week ago