A creditor has lent X to a developing country, which subsequently defaults and enters negotiations with the creditor.

1. Suppose a debtor puts in effort e between 0% and 100% and that e is the probability that a loan X can be repaid with produced output and that otherwise output is zero. What is the expected output produced by effort e.
2. Suppose a creditor can choose to only receive R3. What is the expected payoff for the debtor?
3. If the creditor adopts this forgiveness policy, what is their expected payoff?
4. What is the optimal effort for the debtor if the creditor forgives by R
5. Plot the relationship between e and R.
6. How much should a self-interested creditor forgive?
7. Of what significance is the downward sloping relationship between e and R?
8. Why is this model (due to Krugman) important for international debt forgiveness?
9. What is the difference between moral hazard and adverse selection? Which of these is of concern here? What remedy might there be for this problem?