# Suppose that borrowers can be of two types, safe and risky. The formal lender only knows the probability of each type. Let q be the probability that the borrower is safe

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**ANSWER 3 OUT OF 4**

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**Write clearly and explain your steps where relevant. Type your answers as much as possible. You may draw diagrams by hand making sure that the scanned versions are clear. Longer answers are not necessarily better so answer concisely. You may consult module material but answers should be written up independently without copying and pasting. Marks will depend on how well you demonstrate independent writing in addition to providing correct answers.**

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**1**Suppose that borrowers can be of two types, safe and risky. The formal lender only knows the probability of each type. Let q be the probability that the borrower is safe. The safe project yields m while the risky project yields H with probability p and L otherwise, where L < m < H. Assume that the mean return is the same on both projects. Entrepreneurs have no capital and thus borrow everything to undertake the project. Let the cost of the project be 1, and R be the total required repayment by a lender who incurs total opportunity cost of r for lending the cost of the project. Suppose the market is competitive and there is a limited liability constraint on the lender.

- Explain the problem of adverse selection in the setting outlined above. Discuss what types of equilibria can possibly emerge and whether they are desirable from a social point of view. Diagrams are not required but may be used to illustrate your answer. (15 marks)

- Discuss how microfinance institutions attempt to overcome the problem of adverse selection present in this setting. (10 marks)

**2**Answer the following two subquestions:

- What are the potential and actual problems faced by microfinance institutions in implementing joint liability, as reported in the paper by Ghatak and Guinane in JDE (1999)? (12 marks)

- Jain (JDE, 1999) shows that there can be either symbiosis or crowding out of informal lenders when microfinance institutions enter rural markets in developing countries. Critically interpret and analyse their results, explaining the assumptions these results rely on. (13 marks)

**3**Answer the following two parts:

- Women have been observed to be better credit risks than men in their dealings with microfinance institutions. Critically discuss the reasons that have been offered to explain this. (13 marks)

- Discuss the four main reasons given by Naila Kabeer (“Conflict over Credit: Re-Evaluating the Empowerment Potential of Loans to Women in Rural Bangladesh”, World Development, 2001) as to why quantitative studies of the empowerment effect of loans to women have produced conflicting results. (12 marks)

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**4**Answer the following two parts:

- Outline the basic model of life-cycle savings, making sure to state its assumptions, the maximisation problem and its main theoretical predictions. Then rewrite the maximization problem assuming that in youth, the individual spends part (τ ) of her time in education and the rest (1 − τ ) at work. Each unit of time spent in school raises her human capital in middle and old age respectively by factors Φ and Φt respectively: Φ > Φt > 1. You do not need to derive the first order conditions again. (18 marks)

- Why might life-cycle considerations not be that important in motivating savings by poor households in developing countries? What role can microfinance institutions play in promoting savings by these households?