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Chapter 18: Q. 10 (page 413)

Identify which of the following situations currently faced by the World Bank or the International Monetary Fund are examples of adverse selection and which are examples of moral hazard.

a. The World Bank has extended loans to the government of a developing country to finance construction of a canal with a certain future flow of earnings. Now, however, the government has decided to redirect those funds to build a casino that may or may not generate sufficient profits to allow the government to repay the loan.

b. The IMF is considering extending loans to several nations that failed to fully repay loans they received from the IMF during the past decade but now claim to be better credit risks. Now the IMF is not sure in advance which of these nations are unlikely to fully repay new loans.

c. The IMF recently extended a loan to a government directed by democratically elected officials that would permit the nation to adjust to an abrupt reduction in private flows of funds from abroad. A coup has just occurred, however, in response to newly discovered corruption within the government's elected leadership. The new military dictator has announced tentative plans to disburse some of the funds in equal shares to all citizens.

Short Answer

Expert verified

(a) The World Bank has extended loans to the government of a developing country to finance construction of a canal with Adverse selection.

(b) The World Bank should not extend loans to countries that have failed to repay their loans.
(c) The IMF recently extended a loan to a government directed by democratically elected officials that would permit the nation to adjust to an abrupt reduction are because of Moral hazards.

Step by step solution

01

Introduction.

The International Monetary Fund (IMF) is a 189-member organization that works to promote global monetary cooperation, financial stability, international trade, high employment and sustainable economic growth, and poverty reduction around the world.

02

Adverse Selection (Part a).

The World Bank is currently confronted with two situations: adverse selection and moral hazard.

Adverse selection occurs because the World Bank should exercise caution when extending loans to such projects that may generate sufficient funds to aid in loan repayment.

03

Adverse selection of World bank (part b).

Adverse selections because the World Bank should not extend loans to countries that have failed to repay their loans in full over the last decade.

04

Reasons for the new military dictator has announced tentative plans to disburse some of the funds (part c).

Moral hazard because this would almost certainly protect against misappropriation of funds.

A moral hazard is the idea that if a party is protected from risk in some way, they will behave differently than if they are not protected. Moral hazard occurs in the insurance industry when insured parties take more risks because they know their insurers will protect them from losses.

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Most popular questions from this chapter

In terms of the basic arithmetic of economic growth, through what mechanism do improvements in labor and capital productivity help to boost the rate of growth of per capita real GDP?

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