Transcript 14.2 Financial Considerations in the Short-Run Model A Risk Premium • A risk premium – An extra amount of money charged to compensate for the.

14.2 Financial Considerations in the
Short-Run Model
A Risk Premium
• 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
• 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
• During normal times
– we assume p = 0.
• During a financial crisis
– p rises and interferes with the Fed’s ability to
stimulate the economy.
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.