Problem

Consider the same economy as in exercise 7, but suppose that we now have y = $380, δ = 0.75, and K = $150. Assume that the bank is perfectly competitive, that the borrowers are protected by limited liability, and that the production technology has constant returns to scale (if the loan increases by a factor λ, the borrower's return will increase by a factor λ).

a. Will the bank be willing to extend loans in this case?

b. Now suppose that instead of extending the same loan at date 2, the bank can increase the size of the loan by a factor λ = 1.5 in period 2. Would you expect the bank to actually offer this contract? Briefly explain your answer.