Suppose that you have saved €1,000 this year. Borrowing or lending is not possible because there are no financial markets. If you do not have an investment opportunity that will permit you to earn income with your savings, you will just hold on to the €1,000 and will earn no interest. However, Carl the carpenter has a productive use for your €1,000: he can use it to purchase a new tool that will shorten the time it takes him to build a house, thereby earning an extra €200 per year. If you could get in touch with Carl, you could lend him the €1,000 at a rental fee (interest) of €100 per year, and both of you would be better off. You would earn €100 per year on your €1,000, instead of the zero amount that you would earn otherwise, while Carl would earn €100 more income per year.

As we have seen, Carl the carpenter needs €1,000 for his new tool, and you know that it is an excellent investment opportunity. You have the cash and would like to lend him the money, but to protect your investment you have to hire a lawyer to write up the loan contract that specifies how much interest Carl will pay you, when he will make these interest payments, and when he will repay you the €1,000. Obtaining the contract will cost you €500. When you figure out this transaction cost for making the loan, you realise that you can't earn enough from the deal (you spend €500 to make perhaps €100) and reluctantly tell Carl that he will have to look elsewhere." (Mishkin, Matthews, Giuliodori, The Economics of Money, Banking and Financial Markets, 2013).

Can the deal (contract) still be made even with the €500 charged by the lawyer? How? Which variable in the contract can be changed and by how much?

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In the scenario youve described you face a decision regarding whether to lend 1000 to Carl the carpenter to help him purchase a new tool Youve identif... View the full answer