Reference no: EM131480238

Consider a two period model with credit market imperfections. More specifically, lenders face a pool of borrowers with different risk factors. For simplicity, suppose that fraction a of borrowers is risky and they never pay their debt back. Fraction 1-a of the borrowers is risk-free and they pay back their debt. However, the lenders cannot distinguish between the risky and risk-free borrowers. Therefore, they charge the same interest rate to both type of borrowers. Given that the lending rate is r1, using the zero-profit condition for the lenders, compute the borrowing rate, r2, as a function of the lending rate r1 and the fraction of risky borrowers, a. What happens to the borrowing rate r2 if the fraction of risky borrowers, a, increases? Explain. Determine the effect of an increase in the fraction of risky borrowers on equilibrium prices (real interest rate (lending rate) and wages) and quantities (output, consumption, employment and investment) within the context of a two-period real intertemporal model with credit market imperfections.