Assume that there are two types of borrowers high and low. The high type occurs with probability 0.75 and the low type occurs with probability 0.25. The high type succeeds and generates a gross return of 2 with probability 0.8 and fails and generates a gross return of 0 with probability 0.2. The low type succeeds and generates a gross return of 10 with probability 0.2 and fails and generates a gross return of 0 with probability 0.8. Assume limited liability. In addition, assume that the banking sector is competitive. Furthermore, assume that a commercial bank can secure a gross return of 1 if it makes a deposit at the central bank. Finally, assume that the two types of potential borrowers are DISTINGUISHABLE. What should the gross interest (1+r) charged on loans to low type be in this case?
Assume that there are two types of borrowers high and low. The high type occurs with
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