Conditionality” refers to the specification of certain policies that a government must follow in order to receive loans or assistance from international organizations such as the International Monetary Fund or the World Bank. Here is an example to illustrate one useful aspect of conditionality.

A loan of $10 billion is to be given to a government. Just as in the previous question, the loan may be used in investments, and the government will undertake investments if they pay off at least 10%, but not otherwise. Suppose that the ongoing debt service is $2 billion (and that debt service can only be done if these investments are made). The organization making the loan is happy with a 3% return (especially if the loan helps to service the debt).

(a) Show that if the loan is made without any conditions, it will not be used in investments but consumed, and therefore that the loan will not be made in the first place. In contrast, show that an appropriate commitment from the government in return for the loan will make the international organization, the borrowing government, and the private creditors all better off.

(b) Modify this example to create a case in which both conditionality and some debt forgiveness is required to create a satisfactory solution.