at any interest rate, although they would get credit if the supply of funds were sufficiently
large. This type of rationing is often termed “redlining” (Stiglitz and Weiss 1987).
Due to information asymmetry, the interest rate that a bank charges its customers
affects the riskiness of its loans in two ways. First, there is an adverse selection effect as
the bank sorts its potential borrowers. Secondly, there is an incentive effect as the
interest rate affects the borrowers’ choice of investment projects. That is, the higher the
interest rate, the more preferable riskier projects become to borrowers. Consequently, as
the interest rate increases, more risk averse borrowers do not borrow as their projects
become infeasible, leaving only the risky borrowers in the market. As a result of this
risk-increasing effect of interest expense which decreases their expected returns, and the
sorting effect (adverse selection), the bank does not respond to excess demand by
adjusting their prices. Rather, banks have an incentive to ration credit. There is a concave
relationship between the bank’s expected returns and the interest rate charged (figure 5).
Note that there is no incentive for the bank to lend at interest rates greater than r*. Thus,
even if demand increases, lenders do not respond to higher demand by adjusting their
prices. The risk-increasing effect of interest expense and the screening effect of high
interest rates give rise to credit rationing.
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