Questions: Credit Constraints and Poverty Persistence

Question 1

A rural lender raises interest rates from 20% to 40% annually to compensate for high default risk. According to adverse selection theory, what is the likely unintended consequence?

• A. Higher rates reduce the lender's revenue by discouraging borrowers equally across all risk levels
• B. Higher rates attract riskier borrowers as safer borrowers with lower-return projects drop out, worsening the pool quality
• C. Higher rates motivate poor borrowers to work harder to ensure repayment
• D. Higher rates are passed through to consumers, eliminating the lender's default risk entirely

Answer: (B)

Adverse selection in credit markets means that raising rates screens out safer borrowers first — those with reliable but modest returns who now find the loan unprofitable. Riskier borrowers with high-variance projects remain, since they hope for large upside while the lender bears much of the downside in default. The result can be a deteriorating borrower pool at higher rates, which is why lenders may ration credit rather than simply raising the price of it.

Question 2

A poor farmer with an investment yielding an expected 60% annual return cannot secure a loan. A wealthy neighbor with an identical investment opportunity borrows at 12% interest. The primary reason for this disparity is:

• A. The poor farmer's investment is actually riskier because subsistence farmers lack business experience
• B. The poor farmer lacks collateral to credibly commit to repayment, leaving lenders unable to solve information problems
• C. Lenders prefer wealthy borrowers because they take out larger loans, generating more fee revenue
• D. The poor farmer's expected 60% return is inflated; actual returns on small farms are much lower

Answer: (B)

The key insight is that the investment opportunity can be identical — same expected return, same risk — yet credit access differs based purely on collateral. The wealthy farmer pledges land, which solves both adverse selection (willingness to pledge signals confidence in the project) and moral hazard (she has something to lose if she defaults). The poor farmer has nothing to pledge, leaving the lender unable to distinguish creditworthy from risky borrowers or enforce repayment. The disparity reflects market structure, not underlying investment quality.

Question 3

In a credit market with adverse selection, raising interest rates can worsen the average quality of the borrower pool by causing lower-risk borrowers to exit the market.

• T. True
• F. False

Answer: True

This is the Stiglitz-Weiss mechanism. Safe borrowers have lower-return projects and drop out when rates rise (the loan is no longer profitable for them). Risky borrowers with high-variance projects remain — they still expect to profit if outcomes are good, while losses in bad scenarios are partly absorbed by the lender through default. Higher rates thus select for riskier borrowers, potentially increasing expected defaults and making further rate increases self-defeating.

Question 4

Credit constraints disproportionately affect poor households primarily because their investment opportunities have lower expected returns than those available to wealthy households.

• T. True
• F. False

Answer: False

This reverses the mechanism. Credit constraints bind even when poor and wealthy households have access to identical investment opportunities. A poor farmer may have a high-return project — better than anything available to her wealthy neighbor — yet still cannot access capital. The constraint stems from the absence of collateral to solve information problems, not from low investment quality. Poverty can persist and deepen even when underlying opportunities are equal, solely because starting wealth determines collateral availability.

Question 5

Explain why collateral solves the information problems (adverse selection and moral hazard) that cause credit market failures, and why its absence disproportionately harms poor borrowers.

Model answer: Collateral solves adverse selection because a borrower willing to pledge assets signals confidence in her own project's success — someone expecting to default would not risk losing land or equipment. This separates high-quality borrowers from low-quality ones without the lender needing to observe the borrower's type directly. Collateral solves moral hazard because the borrower now bears part of the downside: if she diverts funds or takes excessive risks, she loses the pledged asset. This aligns her incentives with the lender's. Poor borrowers lack assets to pledge, so neither problem can be resolved. They cannot credibly signal creditworthiness and cannot be credibly disciplined, making lending to them unprofitable even when their investments have high expected returns.

This is why expanding credit access to the poor is not simply about lower interest rates — it requires institutional innovations that substitute for physical collateral. Group lending creates social collateral (reputational stakes within a community) to partially restore both functions.