IS-LM with more complex financial markets

Financial crises in the IS-LM model: introducing a risk premium

Econ 202, Spring 2019 Class 15 (3/26/19)

Today’s plan

• The real cost of borrowing: • Real interest rates (last time). • Adding a risk premium (today).

• The 2008 financial crisis in the IS-LM model, part 2.

Two questions

1. How can we use the IS-LM model to understand what happened to the US economy in 2008?

2. How can we extend the IS-LM model to analyze how financial crises can affect the rest of the economy?

The risk premium

• What is a risk-less investment? • No risk of default. • The FFR (!). • Why?

• Why do firms pay a higher interest rate? • Higher risk of default. • ‘Term’ premium.

• How much higher? Risk premium: ".

Real borrowing rate? # + "

The risk premium

• What is a risk-less investment? • No risk of default. • The FFR (!). • Why?

• Why do firms pay a higher interest rate? • Higher risk of default. • Term premium.

• How much higher? Risk premium: ".

Real borrowing rate? # + "

The risk premium

• What is a risk-less investment? • No risk of default. • The FFR (!). • Why?

• Why do firms pay a higher interest rate? • Higher risk of default. • Term premium.

• How much higher? Risk premium: ".

Real borrowing rate? # + " = ! − '( + "

The risk premium & financial crises:

• Typically, the risk premium is constant. • Changes in ! capture changes in real borrowing costs (" + $).

• But during crises: • The central bank reduces !. So " falls. • But lending is riskier. So $ increases. • Real borrowing costs?

What determines the risk premium?

1. Probability of the borrower defaulting.

2. The degree of risk aversion of the lender.

3. The ability of lenders to bear risk.

Taking it back to the IS-LM model

• The IS curve: ! = # ! − % + ' !,) + * + +

• The LM curve: • The central bank picks ,. • It can, similarly, pick ). • The central bank targets a real policy rate ()- = )̅). • If not at Zero Lower Bound.

Echo 360!

Macroeconomic shocks

• Now we also have financial sources of shocks.

!

"

#$

%&

"' = "∗

!∗ %&*

!*∗