Question

This Problem is about Finance in the IS/LM Curve, please use formulas to support the answer.

1. Suppose the probability of borrower default increases, driving up the market interest rate. Show the effect of this shock in the IS/LM graph and briefly explain the changes to the macroeconomics, indicators on the graph.
2. Suppose the real market interest rate is 6%. The risk premium is 7.5%. The inflation rate is 3%. Find the nominal policy rate (FFR) and decide if the money market is at the zero lower bond.

Answer 1

Increase in the probability of defaults leads to increase in interest rate as banks fear default and so it increases the cost of money. this makes investment costly so demand for investment fals.

Y=C+I+G+NX

as I falls, output Y also falls from Y1 to Y2.

In the r-y plane, as output falls IS curve shifts down from IS1 to IS2

the fall in output results in fall in money demand because Md= kY-lr

where k and l are positive constants.

in the money market, as demand for money falls, that for bonds rise. price of bonds increase and so the interest rate falls from r2 to r3. this shifts the LM curve downwards. the fall in interest rate increases investment and output increases back to Y1.

2) nominal interest rate= (( 1+real interest rate)*(1+inflation rate))-1

= (1.06*1.03) - 1

= .0918

=9.18%

Given that the risk premium is 7.5%<9.18%

Zero-bound interest rate is a reference to the lower limit of 0% for short-term interest rates beyond which monetary policy is not believed to be effective in stimulating economic growth

so money market is above the zero bound