lecture 6 Flashcards
What is the key difference between nominal and real interest rates?
- Nominal interest rate: Measured in units of currency (e.g., €).
- Real interest rate: Measured in terms of purchasing power, i.e., baskets of goods, adjusted for expected inflation.
What two main factors determine the risk premium on a bond?
- Probability of default (higher default risk → higher premium).
- Degree of risk aversion (more risk-averse investors demand higher premiums).
Define leverage ratio (LR) and capital ratio (CR) in financial intermediaries.
- Leverage ratio (LR): LR = Assets Capital LR=CapitalAssets
- Capital ratio (CR): CR = Capital Assets CR=AssetsCapital Higher LR increases expected profit but also raises risk.
What are two typical solutions to prevent a bank run?
- Federal deposit insurance (guarantees deposits to prevent panic).
- Narrow banking (restricts banks to holding only liquid assets).
How does unconventional monetary policy stimulate long-term investment when interest rates are near zero?
The central bank buys long-term bonds, increasing demand and lowering their yield, which reduces long-term borrowing costs, encouraging investment.
In the IS-LM model with financial frictions, why might lowering the policy interest rate not stimulate borrowing?
If the risk premium (x) increases due to financial instability, the real interest rate paid by borrowers remains high, making loans expensive and reducing investment.
What are subprime mortgages, and why did they contribute to the 2008 financial crisis?
Subprime mortgages were loans given to borrowers with poor credit histories, initially at low interest rates but later adjusted higher. When housing prices fell, many borrowers defaulted, triggering massive bank losses.
What role did high leverage play in the 2008 financial crisis?
Banks underestimated housing market risks and took on high leverage, leaving them unable to cover losses when housing prices collapsed, leading to bankruptcies.
How did the risk premium negate the effect of the Federal Reserve lowering interest rates during the 2008 crisis?
Although the Fed lowered the nominal interest rate (e.g., to 3%), a rising risk premium (x) (e.g., +2%) led to a real borrowing rate of 5%, keeping loans expensive and preventing economic recovery.
