Topic 3: IS-LM Model 2

Question 1

What is the nominal rate (i)?

Answer 1

What you see (e.g., 2%)

Question 2

How is the real rate (r) calculated?

Answer 2

r = i - π^(e)t+1

Question 3

What happens to the real interest rate when inflation expectations rise?

Answer 3

Real interest rate falls

Question 4

What is the significance of the zero lower bound (ZLB)?

Answer 4

Important when nominal interest rates are zero

Question 5

What is the formula for interest rate with a risk premium?

Answer 5

I + i + x (where x = risk premium)

Question 6

When is the risk premium (x) larger?

Answer 6

• Probability of default is higher
• Lenders are risk-averse
• Market uncertainty is higher

Question 7

What type of bonds typically have a low or zero risk premium?

Answer 7

Government bonds (e.g., US treasury)

Question 8

What type of bonds typically have a high risk premium?

Answer 8

Corporate bonds (e.g., BBB-rated)

Question 9

What are the main assets of banks?

Answer 9

• Loans
• Bonds
• Reserves

Question 10

What are the main liabilities of banks?

Answer 10

• Deposits
• Borrowings

Question 11

What does the Capital Ratio represent?

Answer 11

Capital/Assets

Question 12

What does the Leverage Ratio represent?

Answer 12

Assets/Capital

Question 13

What is the trade-off of high leverage in banks?

Answer 13

Higher profits but increased risk of insolvency

Question 14

What is the original IS equation?

Answer 14

Y = co + c1(Y - T) + I(Y, i) + G

Question 15

What is the extended IS equation?

Answer 15

Y = Co + C1(Y-T) + I(Y, i - π^e + x) + G

Question 16

What does π^e represent in the context of the IS equation?

Answer 16

Expected inflation

Question 17

What is the definition of inflation?

Answer 17

πt = (Pt - Pt-1) / Pt-1

Question 18

What does the term ‘zero lower bound’ refer to?

Answer 18

If nominal interest rates are zero, people are indifferent between holding money and bonds

Question 19

What triggered the 2008 financial crisis?

Answer 19

Subprime Mortgage Collapse

Question 20

What characterized the housing market from 2000-2006?

Answer 20

Sharp increase in US house prices

Question 21

What did low interest rates encourage during the 2008 financial crisis?

Answer 21

Borrowing

Question 22

What are NINJA loans?

Answer 22

Loans given to people with no income, no job, no assets

Question 23

What are teaser rates?

Answer 23

Initially low repayments that increase later

Question 24

What happened to housing prices after 2006?

Answer 24

Decline in housing prices leading to economic slowdown

Question 25

What were the estimated mortgage losses by mid-2008?

Answer 25

$300 billion (-2% of US GDP)

Question 26

What were some fragilities in the financial system during the crisis?

Answer 26

* High leverage * Securitisation of risky mortgages * Wholesale funding reliance

Question 27

What was a consequence of the default surge during the crisis?

Answer 27

Global panic and funding freezes

Question 28

What were the economic impacts of the 2008 financial crisis?

Answer 28

* Borrowing costs rose * Uncertainty spiked * Collapse in consumer and business confidence

Question 29

What was a key consequence of the financial crisis in Europe?

Answer 29

Direct exposure to US mortgages and failing exports

Question 30

What financial support measures were taken during the crisis?

Answer 30

* Liquidity injections * Toxic assets removal * Capital support for banks

Question 31

What monetary policy actions were taken during the crisis?

Answer 31

* Sharp cuts in interest rates * Use of quantitative easing (QE)

Question 32

What fiscal stimulus measures were implemented during the crisis?

Answer 32

* Increased government spending * Tax cuts

Question 33

What were some key consequences of the financial crisis?

Answer 33

* High unemployment * Government debt surged * Private debt levels remained high * Interest rates stayed near zero