Question

In: Economics

Answer the following questions about the risk premium: a) What happens to the interest rate (r)...

Answer the following questions about the risk premium:

a) What happens to the interest rate (r) and output (Y) when the risk premium increases, holding everything else constant? Do they increases, decrease, and/or stay the same? Use the IS-LM graph to show the effect of the increase in the risk premium. (Hint: To answer this question you will need to clearly label multiple LM curves. Assume the IS curve has a “normal” downward slope.)

b) How does the risk premium relate to one of the possible reasons why the Fed can lose control of the economy?

c) Why did the increase in the risk premium between the years 2007-2008 help explain how the crisis in the relatively small U.S. subprime mortgage market was amplified into the Global Economic Crisis?

Solutions

Expert Solution

a) When risk premium increases, the domestic rate of interest also increases, this will in turn reduce the investment spending and aggregate demand, and shift the IS curve leftward, However, higher interest rate reduces the demand for money as people don't want to borrow money at higher rates of interest, shifting the LM curve rightward, output Y has to increase in order to restore the money market equilibrium. So, the increase in risk premium causes an increase of both Y and r, and causes the decrease or depreciation of the exchange rate. Take a look at teh adjoined fig.  

b)  When the risk premium in an ecomony increases, money plays the role of that safe store of value/asset, investment is reduced, investment is too high during the boom phase, when risk is low, and investment is too low during slump phase, when risk is high, money is superneutral and monetary policy can't correct such a situation. The spikes in risk premium consequently lead to the depression of business demand for capital and labour, increases the firm's uninsurable risk, increasing the risk premiums. Such risk shocks lead to contractions in employment, consumption, investment etc. Business cycles turn inefficient. Though the income increases, there is a fall in the exchange rate, so increases in risk premium are not desirable. Thus, increase in risk premium can be a possible reason of Fed losng control of economy.

c) The breakdown of the Lehman brothers in 2008, sent waves of horror and fear across the world financial markets. Banks restrained from lending to each other, and so the risk premium on interbank borrowing increased sharply to 5%,the risk premium on corporate bonds also increased and by even more than 6%, corporate sector stopped borrowing, trade credit was unavailable, there was falling demand for investment goods, leading to sharpest drop in global economic activity during global financial crisis. The increase in risk premium was quite significant during the periods of US subprime mortgage crisis as this crisis was associated with highest level of risk aversion and systematic risk. So, the risk averse investors required a larger risk premium which is basically the additional remuneration demanded by investors in order to invest in risky assets. There was a strong and obvious relationship between the increase in market risk and decrease in equity value. So, the substantial increase in stock market risk during financial crisis had a significant impact on equity/capital market and led the small mortgage market crisis into global economic crisis.


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