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14.2 Financial Considerations in the Short-Run Model

14.2 Financial Considerations in the Short-Run Model. A risk premium An extra amount of money charged to compensate for the probability that a loan will not be repaid This was responsible for the spread in interest rates. Interest rates moving in the wrong direction

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14.2 Financial Considerations in the Short-Run Model

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  1. 14.2 Financial Considerations in the Short-Run Model • A risk premium • An extra amount of money charged to compensate for the probability that a loan will not be repaid • This was responsible for the spread in interest rates. • Interest rates moving in the wrong direction • Deepening instead of mitigating the downturn A Risk Premium

  2. We can incorporate the risk premium into our short-run model. Real interest rate Real interest rate at which firms borrow in financial markets Risk premium

  3. During normal times • we assume p = 0. • During a financial crisis • p rises and interferes with the Fed’s ability to stimulate the economy.

  4. A Rising Risk Premium in the IS/MP Framework • To stabilize the economy after the bursting of a housing bubble • The Fed may lower the interest rate to stimulate the economy. • Counteracts the negative aggregate demand shock.

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