IS-LM model 2 Flashcards
nominal vs real interest rates (equation and 2008)
relationship: rt=it-pi^e t+1
-rt= real interest rates, it= nominal interest rates (base rate), pi^et +1= expected inflation
-2008: nominal interest rates have been close to 0 in many advanced economies
example of nominal vs real interest rates
- i want to buy a laptop in a years time. i have £1000 now and I want to use this to buy a laptop in one year, I put it into a cash ISA with a nominal interest rate of 2%.
-expected inflation at 2%, savings with nominal of 2%, real interest rate= 0%
-if expected inflation is 10&, real interest rate would be -8%
risk and risk premiums (limitation/ real world applications, equation and factors which affect risk premiums
limitation/ real world apps: limitation os IS-LM model is we assumed single i.r. in the real world there are many different i.r.’s faced by governments, households firms
-equation: i.r. with a risk premium can be expressed as 1+i+x
-factors: governments in advanced economies face low (x is 0), other areas risk premium will be higher
-x increases as: probability of default increases, lenders more risk averse and more uncertainty
risk premiums in 2008
-up to Jan 2006, good economy and low volatility
-after 2008, BBB and AAA and treasury bonds premium increased, September 2008 even worse
-however, through policy intervention (Q.E.), economy began to stabilise
financial intermediaries
-IS-LM model assumes the central bank sets interest rate in the economy, in reality there are many different types of financial intermediaries
-these develop expertise about specific borrowers and tailor lending to their needs
-they borrow and lend above rates set by central bank to make profits
balance sheets: capital, bank liabilities and bank assets
-capital: initial cash injection from owners (what you own)
-bank liabilities: borrowing from other investors/banks, interest paying deposits (what you owe)
-capital: reserves, loans to consumers/firms/other banks
example of a balance sheet
-assets on left (100k), = liabilities (80k) and capital (20k) on right
capital ratio, leverage ratio, bank profit and profit per unit of capital
-capital ratio: capital/assets
-leverage ratio: assets/capital
-bank profit: (assets x return on assets)- (liabilities x return on liabilities)
-profit per unit of capital: bank profit/capital
issues if investors become unsure about value of assets
-value of assets will decline
-if investors want to withdraw funds, banks must find the funds to pay but it may be difficult to recall loans quickly and bank could quickly run short of liquidity
-bank liabilities can be withdrawn quickly whereas assets cannot be
-may be unable to sell assets/ may have to sell them at fire sale prices
extending the IS-LM model with risk premium
-Y=C0+c1(Y-T)+I(Y, It-pi^e t+1+x) + G
assumption made in short run and equation to find this out
-key assumption is that prices stay fixed in the short-run
-if prices are fixed, rate of inflation is 0, then expected inflation will be 0 (pit=pit+1=0) then nominal and real interest rates will be equal (rt=It)
-inflation (Pit)= (Pt-Pt-1)/(Pt-1)
IS and LM return after key assumption and zero lower bound
-IS return: Y=C0+C1(Y-T)+I(Y, r+x)+G
-Lm return: r=ř
-zero lower bound: if nominal ir=0 people are indifferent about holding money/loans (nominal ir=0)
summary of changes made to IS-LM (and graph to show 2008 recession)
-summary of changes: replace i with r (no inflation in the model), equation for investment in goods now includes risk premium (r+x)
-graph to show 2008 recession:
-set up IS-LM as normal (now r instead of i)
-rise in risk premium, fall in investment, fall in output, fall in consumption and investment (negative multiplier)
-IS shifts right (r does not change)
policy response to 2008 financial crisis
1) rise in deposit insurance threshold (if UK banks fail services compensation scheme pay customers up to 85k)
2) widespread liquidity to financial system (through monetary policy- QE)
3) intervention to remove toxic assets from financial system
4) capital injections to banks
5) rapid decline in c.b. interest rates
6) unconventional monetary policy
7) fiscal stimulus package
-graph to show effects of monetary policy after 2008 and brief explanation of fiscal policy
-set up standard IS-LM model (with new changes)
-rise in risk premium, AD falls (due to fall in investment), fall in output, fall in consumption/investment- effects to IS curve: shift left in IS, money demand shifts left
-effect of monetary policy: government reduces r (cheaper to borrow- more investment/ consumption) and subsequently reduces LM, output rises (mini multiplier) but not to same levels as before
effect of fiscal policy:
-fall in taxes, raise in government increases consumption and investment increase AD, i.r. does not change, money demand will shift
