Are high interest rates exploitative or efficient Should government intervene

Are high interest rates exploitative or efficient

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- Are high interest rates exploitative or efficient ? - Should government intervene? Who should get credit? Efficiency: cost of capital is the minimum interest rate $0.20 per dollar: projects with return of $0.15 excluded Uncertainty: even high return projects fail Expected return: 75%*0.40 + 25%*0 = 0.30 Credit market imperfections Monopoly : costs high or because it is a monopoly? (high transaction costs, default, information costs). Information (agency) problems : moral hazard, adverse selection (limited liability). ² Limited liability: Lending to poor strangers is risky Downloaded by Vicky Gupta ([email protected]) lOMoARcPSD|3929542
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Limited liability LL Borrowe r prefers risky project because they are not punished for losses but rewarded for wins. Banks; lower interest rates to have 50% safe and 50% unsafe borrowers (higher there are only risky projects left). > example of credit constraints; profitable projects are available but no one is investing LL: Lender Strategies LL creates excessive downside risk for lender; what to do? 1. Collateral (onderpand): reduce information need 2. Information: reduce information asymmetry (= deals with the study of decisions in transactions where one party has more or better information than the other, access to different information.) Screening, monitoring 3. Rationing: take into account borrowers’ default (verzuim) incentives when writing contract Credit rationing ‘At the going rate of interest the borrower would like to borrow more money but is not permitted to by the lender’ (Ray, 548) Result : credit constraints; less growth, more poverty! We discuss two types: Default related (moral hazard: is a situation where a party will have a tendency to take risks because the costs that could incur will not be felt by the party taking the risk ) Borrower risk type (adverse selection It refers to a market process in which undesired results occur when buyers and sellers have asymmetric information; the "bad" products or services are more likely to be selected ) Default and enforcement L = loan size, A = earning at outside option No default constraint: f(L)- N/(N-1) L(1+i) A N = n periods; after default in period 1 no more loan, A = profit when borrows from other source If A goes up: default goes up (harder to meet default constraint). N increases: decreases defaults (number of periods where you get punished = N). Default constraint lowers the amount of credit given out (below optimal level). Credit rationing in equilibrium Money lender keeps interest rate at participation maximum But reduces loan size to L1 to also meet the pay back restriction At this interest rate borrower would want to borrow more: credit rationing in equilibrium A i L L f + - ) 1 ( ) ( Downloaded by Vicky Gupta ([email protected]) lOMoARcPSD|3929542
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Screening and enforcement - Need collective action and information sharing to identify bad borrowers.
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