The government of Bolivia takes out a loan of fixed size (L) and agrees to pay r interest on it. The loan is extended by a group of large banks in New York. The loan is due in one year’s time. If Bolivia chooses to default, it will lose a fraction c of its income (Y ) due to trade sanctions and other financial distress. The rest will be consumed. Otherwise, the country can pay principal and interest on the loan and consume whatever is left. The level of income in one year’s time is unknown when the terms of the loan are decided. Both lenders and the borrower face the same uncertainty over its eventual realization.
1. Use a diagram to argue that default will happen if and only if income in one year’s time is below a certain threshold level. Solve for that threshold.
2. In no more than 1 paragraph, explain intuitively why this setup might have two equilibria, one in which the interest rate is high and another in which Bolivia borrows cheaply.