Topics in Applied Microeconomics

(part 2 by Prof.)

This coursework is worth 100 points. Answer both questions and submit a Word file with your answer. Include your name and City´s email in all your pages. Use only the available space to answer.
Question 1 (50 points)
Consider the following credit market of a simple economy where entrepreneurs do not own capital of their own. There is limited liability and borrowers cannot be prosecuted for being unable to pay back loans to banks if their projects fail. All borrowers are risk neutral.
– There are 2 types of borrowers. Safe and risky. Available information determines that 1/2 of borrowers are of each type.
o Safe borrowers require $1000 capital to develop projects that would produce revenues for $2000 with certainty.
o Risky borrowers require $1000 capital to develop projects that would produce revenues for $3000 with probability 0.5 and $0 with probability 0.5.
– Banks do not know the borrowers´ type. They charge interest rate r to each loan. Each $1 lend has to be borrowed from capital markets at interest rate k. Banks are risk neutral and obtain zero expected profits.

Q1.a.(10 points) Consider a safe borrower. What is the maximum interest rate that they would consider asking for a loan? Justify your answer.

Q1.b.(10 points) Consider a risky borrower. What is the maximum interest rate that they would consider asking for a loan? Justify your answer.
Q1.c. (10 points) Compute the bank’s expected profit for a $1000 loan, for all possible values of r and for a value of k=60% (i.e. the cost of getting the funds to lend).

Q1.d. (20 points) Suppose now that banks have zero expected profits. What would be the observed interest rate?
Question 2 (50 points)
Q2.a. (30 points) Consider the framework of Question 1, including the zero profit condition for banks. Assume now that the government offers a $500 warranty to the bank if the borrower’s project fails. What would be the effect on the interest rate?

Q2.b. (20 points) Based on the experience given by the Grameen Bank. Can you propose an alternative to reduce interest rates?