Suppose a credit market with a good borrowers and 1-a bad borrowers. The good borrowers are all identical, and always repay their loans. Bad borrowers never repay their loans. Banks issue deposits that pay a real interest rate r1, and make loans to borrowers. Banks cannot tell the difference between a good borrower and a bad one. Each borrower has collateral, which is an asset that is worth A units of future consumption goods in the future period.
(a) Determine the interest rate on loans made by banks.
(b) How will the interest rate change if each borrower has more collateral?
(c) Explain your results, and discuss.