6. Financial Markets II : The extended IS-LM model

Question 1

Nominal VS Real interest rates

Answer 1

Nominal interest rate(i^t) - interest rate expressed in terms of dollars or in national currency
Real interest rate (r^t) - interest rate expressed in terms of basket of goods
r^t≈ i^t-π_(t+1)^e
1. When expected inflation =0, than real interest rate=nominal interest rate.
2. When the expected inflation rate is positive, the real interest rate is typically lower than the nominal interest rate.
3. The higher the expected rate of inflation, the lower the real interest rate
4. The lowest real policy rate the central bank can achieve is the negative of inflation

Question 2

Risk and Risk Premia

Answer 2

Risk premium on bonds - the additional interest rate a bond has to pay, reflecting the risk of default on the bond
Risk premium (x) - The difference between the interest rate paid on a given bond and the interest rate paid on a bond with highest rating
x= (1+i) p / (1-p)
• risk premium (x) ↓ => borrowing rate ↓ => output and demand ↑
(1+i)=(1-p)(1+i+x)+(p)(0) => to get the same expected return on the risky bonds as on the riskless bonds
Risk aversion - a risk averse investor is an investor who prefers lower returns with known risks rather than higher returns with unknown risks

Question 3

The role of financial intermediaries

Answer 3

Capital ratio (bank reserve) = capital / assets (more power to have more profits at a risk)
Leverage ratio = assets / capital (the amount of money a bank keeps as a reserve in case of bad times)

Question 4

Extending the IS-LM model

Answer 4

IS relation: Y=C(Y-T)+I (Y,i-π^e+x)+G
LM relation: i = ibar

IS relation: Y=C(Y-T)+I (Y, r+x)+G
LM relation: r = rbar