Economy with Two Distinct Production Projects

In this chapter all symmetric and asymmetric Nash equilibria of the interest rate game introduced in Chapter 3 (Interest Rate Game and Symmetric Equilibria) are characterized in an economy in which borrowers undertake a safe or a risky project. Risky entrepreneurs accept a higher loan rate than safe entrepreneurs. Every bank offers a loan rate that makes one of both entrepreneurial types indifferent between saving and investing. This chapter makes the effect of bank equity and its distribution on credit rationing visible: If aggregate equity in the banking sector is low, all banks offer expensive loans. Otherwise, rich banks offer cheap loans and poor banks offer rejected applicants expensive loans. The return on expensive loans can exceed the deposit rate, which results in a positive equilibrium interest margin.