Reference no: EM133124224

Suppose that the typical moneylender has 10,000 pesos to lend out to farmers in the village and the opportunity cost of his funds (what the lender can get if he puts his funds in the bank) is 10 % per annum.

a.) What will be the minimum interest rate that will be charged to farmers in the village if the probability of repayment is 100%? (Hint: calculate the moneylender's expected profits from making the loan.)

b.) How does your answer to A) change if the probability of repayment falls to 60%? What can you conclude about how risk affects the interest rate that lenders charge? In the context of this application, explain why interest rates are often not used as a market clearing device in rural credit markets.

c.) Suppose the moneylender has no information on the type of borrower and has to charge a single interest rate to all borrowers. She assumes that the probability she ends up with a high quality borrower (with 100% probability of repayment) and low quality borrower (only 60% probability of repayment) is equal. In this case, what is the minimum interest rate that the moneylender will be willing to charge to break even?

d.) Using the above example, explain why the moneylender would have little incentive to make loans. Carefully explain the root cause of the moneylender's problem.