The extended IS LM model Flashcards
(23 cards)
What are the two types of interest rates discussed?
Nominal interest rate and real interest rate
What does the real interest rate account for?
Purchasing power and expected inflation
What is the formula to relate nominal interest rate and real interest rate?
1 + rt = (1 + it) / (1 + πe)
True or False: A higher expected inflation leads to a higher real interest rate.
False
What is the effect of high inflation on borrowing and lending?
Borrowing is more convenient when inflation is high; lending is convenient when inflation is low
What defines the risk premium for bonds?
Probability of default and degree of risk aversion of bond holders
Fill in the blank: The real interest rate is approximately equal to the nominal interest rate minus _______
expected inflation
What is a financial intermediary?
A financial institution that receives funds from investors and lends them to others
What are the effects of a financial crisis on borrowing costs?
Increased risk premium leading to higher borrowing costs
What is the capital ratio?
The ratio of capital to assets
What happens to banks when liabilities can be withdrawn with short notice?
Increased risk of fire sales and bank insolvency
Define the term ‘narrow banking’.
Restricting banks from making loans and forcing them to hold liquid and safe government bonds
What did the US introduce in 1934 to limit bank runs?
Federal deposit insurance
What is the relationship between the Central Bank’s policy rate and borrowing rates?
The borrowing rate is influenced by the policy rate plus the risk premium
What is the implication of a high leverage ratio for banks?
Higher expected profit rate but also higher risk of insolvency
What is securitization?
Creation of securities based on a bundle of assets, such as mortgage-based securities
What happens to the IS curve when there is an increase in the risk premium?
The IS curve shifts to the left, decreasing equilibrium output
What is the effect of monetary policy on the risk premium?
Decreasing the real policy rate can offset the increase in the risk premium
What is the expected change in price of a good denoted by?
π (pi)
What unconventional monetary policy did the Fed use during the crisis?
Quantitative Easing (QE)
QE involved buying assets like mortgage-backed securities to decrease risk premiums.
What effect did the financial crisis have on the IS curve?
Shifted to the left
This shift indicated a decrease in aggregate demand.
What was the effect of financial and fiscal policies on the IS curve?
Shift back to the right
These policies aimed to restore demand after the crisis.
What effect did monetary policy have on the LM curve?
Shifted down
This shift aimed to lower interest rates and increase the money supply.
