Risk is a crucial characteristic of understanding interest rates. Interest rates are critical to the loanable funds market. This exercise aims to understand better how risk directly factors into interest rates. Let's try this example.

Pretend you are a bank that has no costs whatsoever. Further, you're a non-profit bank whose only goal is to break even. Explain what you need to set your interest rate in the following situations tobreak even.

• You have ten people who are going to each borrow $1000. You expect 1 out of these ten will default on their loan and pay you back nothing.(Hint, you need to get back $10,000 in money from 9 people. Each will have to pay $10,000/9=$1,111. That means they would have to pay you $111 interest on a $1000 loan. To calculate the interest rate ((1111-1000)/1000) = 11% would be the interest rate this group would have to pay.)
• You have 100 people who are going to each borrow $1000. You expect 1 out of these 100 will default on their loan and pay you back nothing.
• Who will pay a higher interest rate? Why? How much of this difference in interest rate is due to the profit motive?
• Can this help explain the paradox that the poor (Countries or People), who can less easily afford higher interest rates, are often charged a higher rate? What do you think this does for long-term growth for these populations?