Paraphrase

Q1 Provide a clear explanation for why asymmetric information can lead to credit rationing. A complete answer will reference at least the ideas of moral hazard, adverse selection, and loan defaults. Answer: ​Problem of asymmetric information affects the borrower lender relationship between a firm and her bank. Credit rationing is a situation when banks are unwilling to advance additional funds to borrowers even at a higher interest rate and limit the supply of loans .

Credit rationing occurs when the lender's expected return declines due to ADVERSE SELECTION, MORAL HAZARDS, and LOAN DEFAULTS.

Rise in the interest rate doesn't make any difference in the lender's expectations.

CREDIT MARKET AND ADVERSE SELECTION----- Credit rationing occurs as a consequence of the adverse selection problem. A risk neutral ,competitive bankfaces credit demand from firms. Each firm applies for loan for an investment project.Credit demand is a monotonically decreasing function of the repayment level. This problem can be solved by introducing collateral into the credit contract.

MORAL HAZARD----- Under asymmetric information,it is assumed that only the investing firm but not the credit extending bank can observe the actual amount of profit at no cost.This is the case of moral hazard with hidden knowledge.To minimise the moral hazard problem, the bank offers a loan contract .

LOAN DEFAULTS------ loan default occurs when a borrower fails to pay back a debt according to the initial arrangement.In such cases, successive payments are missed over a course of weeks or months. In this case, the only remedy to banks/ lenders is credit rationing.

Q2 Explain why asymmetric information increases the likelihood that lenders will discriminate against potential borrowers on the basis of factors unrelated to ability to repay loans; e.g. factors like race, family size, gender.

Answer: ​Asymmetric information is a situation in which both the parties in the transaction do not have the same level of material information. This can lead to adverse selection in lending because people with bad credit records are more likely to apply for loans and they are more likely to receive it because the lenders do not have sufficient information about the borrowers. In order to avoid this situation, lenders would like to gather as much information about the borrower as possible. Even though the lender should ideally focus on the economic factors, the lenders might also verify factors like race, gender, religion, size of the family according to the general perception of the lender. The lender might not extend loans to various parties on the basis of such factors because of the negative perception in the mind of the lender. Such situations of distrust mainly occur because of information asymmetry.