Extended IS-LM model

Question 1

nominal interest rate and real interest rate

Answer 1

nominal: expressed in currency units (If 𝑖𝑡 = 5%, then borrowing 1$ today requires you to pay 1 + 𝑖𝑡 = 1.05$ tomorrow)

real: expressed in terms of value of goods (If 𝑟 𝑡 = 2%, it means that borrowing the monetary equivalent to 1
basket of goods today requires you to pay the monetary
equivalent of 1 + 𝑟𝑡 = 1.02 baskets of goods tomorrow)

Question 2

explain financial crisis

Answer 2

2000-2006: Increase in house prices due to:
• Unusually low interest rates stimulated mortgage demand.
• Mortgage lenders were profiting with subprime mortgages (incl. NINJA).
From 2006: house prices decline sharply
• Many mortgages went underwater.
• Lenders faced large losses as many borrowers defaulted.

In the build up to 2008, banks became increasingly leveraged
• Some of the assets (i.e. subprime) go bad (from 100 to 85)
– When assets decline, the value of capital lowers too
– Investors confidence declines and withdraw deposits/make lending to banks more expensive
– Banks want to liquidate assets but can only do it at fire sale prices (from
85 to 75)
– Assets < liabilities = technical insolvency and no further lending. Banking
crisis becomes macro.

Question 3

financial intermediaries

Answer 3

institutions (bank or non-bank) that intermediate between borrowers and lenders, profiting from the interest rate spread between assets and liabilities

Question 4

leverage

Answer 4

assets-to-capital ratio

– The higher the leverage, the higher the profit
– The higher the leverage, the higher the risk of insolvency

Question 5

financial policy response to GFC

Answer 5

– Increasing liquidity provision to banks – to sustain assets’ value
– Insuring deposits – to avoid bank runs on deposits
– Troubled Asset Relief Programme (TARP) – to increase bank capital

IS curve shifts right

Question 6

monetary policy response to GFC

Answer 6

– Decreasing policy rate to ZLB (LM shifts down)
– Quantitative easing (IS shifts right via risk premium x)

Question 7

fiscal policy to GFC

Answer 7

– Automatic stabilisers
– Discretionary stimulus

Question 8

narrow banking

Answer 8

Narrow banking would restrict banks to holding liquid and safe government bonds, like T-bills. Loans would have to be made by financial intermediaries other than banks. This would likely eliminate bank runs. Some recent changes in US regulation have gone in that direction, restricting banks that rely on deposits from engaging in some financial operations, but they stop far short of imposing narrow banking. One worry with narrow banking is that, although it might indeed eliminate runs on banks, the problem might migrate to shadow banking and create runs there.

Question 9

TRUE OR FALSE: When expected inflation increases, the real rate of interest falls

Answer 9

Uncertain. Statement is true when the nominal rate of interest does not change.

Question 10

TRUE OR FALSE: Banks and other financial intermediaries have assets that are less liquid than their liabilities.

Answer 10

True. This is a characteristic - and function - of banks. They create relatively liquid assets for its depositors (i.e., demand deposits) while holding relatively illiquid assets itself. This is why banks are fragile institutions.

Question 11

TRUE OR FALSE: The interest rate which the private sector pays to borrow money from banks is set by the central bank.

Answer 11

False. The central bank sets the policy rate on loans and reserves to commercial banks, which usually affects the credit market rate charged by banks and financial intermediaries. Here you can distinguish between lending and deposit rates, mortgage rates, rates on loans of different maturities. Student should understand that each borrower is charged with a specific rate depending on its own features, bank features, and macro conditions. When we talk
generally about interest rates on lending, we refer to the average rates.

Question 12

suppose that the perceived value of the bank’s assets falls. If lenders are nervous about the solvency of the bank, will they be willing to continue to provide short-term credit to the bank at low interest rates?

Answer 12

If lenders are nervous about the solvency of the bank, they will not be willing to provide short-term credit to the bank at low interest rates.

Question 13

Assuming that the bank cannot raise additional capital, how can it raise the funds necessary to repay its debt coming due? If many banks are in this position at the same time (and if banks hold similar kinds of assets), what will likely happen to the value of their assets? How will this affect the willingness of lenders to provide short-term
credit?

Answer 13

The bank must sell assets. If many banks are in this position and selling the same kind of assets, the value of these assets will fall. This will worsen the value of bank capital and make lenders more nervous.