# ECN 327 Macroeconomics 7th Edition by Blanchard, Chapter 06

Chapter 6 – Financial Markets II
Learning Objectives Understand the difference between Nominal
and Real Interest Rates Understand the Role of Risk Premia
Understand the Role of Financial Intermediaries Know the Extended IS-LM Model
Understand how the Housing Problem led to the Financial Crisis
Chapter 6 Outline Financial Markets II
6-1 Nominal versus Real Interest Rates 6-2 Risk and Risk Premia
6-3 The Role of Financial Intermediaries 6-4 Extending the IS-LM
6-5 From a Housing Problem to a Financial Crisis
Until now, we assumed that there were only two financial assets—money and bonds—and
just one interest rate—the rate on bonds—determined by monetary policy. The financial system also plays a major role
in the economy. This chapter looks more closely at the role
of the financial system and its macroeconomic implications.

6-1 Nominal versus Real Interest Rates
Nominal interest rate is the interest rate in terms of dollars. Real interest rate is the interest rate in
terms of a basket of goods. We must adjust the nominal interest rate to
take into account expected inflation. Figure 6-1 shows the Definition and Derivation
of The Real Interest Rate. If you loan money today in terms of goods
say a cup of rice, then after one year you get back
a little over one cup of rice.

Then the extra rice you got is the real return
on your loan. One good today is after one year equal to
(1+rt) goods. To derive the formula for the real rate, start
by considering you invested in one good by buying it for its
price, Pt. After a year, if nominal interest rate is
it, then you have Pt (1+it) dollars. After
one year the Price level will be Pt+1.

If we adjust the nominal return by dividing
it by the new Price level we will get the real
return or the real interest rate earned on the investment of buying one good for Pt dollars. Equations 6.1, 6.2 and 6.3 help us in understanding
the relation between real interest rate, nominal interest rate and
expected inflation rate If the nominal interest rate and expected
inflation are not too large, a close approximation to equation (6.3) is given by
equation 6.4 which says that the real interest rate in year t is approximately equal to the
nominal interest rate in year t minus the expected inflation rate over that year. When expected inflation equals zero, the nominal
interest rate and the real interest rate are equal.

Because expected inflation is typically positive,
the real interest rate is typically lower than the nominal interest rate. For a given nominal interest rate, the higher
expected inflation, the lower the real interest rate. The real interest rate (i ? ?e) is based on
expected inflation, so it is sometimes called the ex-ante (“before the fact”) real
interest rate. The realized real interest rate (i ? ?) is
called the ex-post (“after the fact”) interest rate. The interest rate that enters the IS relation
is the real interest rate. The zero-lower bond of the nominal interest
rate implies that the real interest rate cannot be lower than the negative of
inflation. Figure 6-2 shows Nominal and Real One-Year
T-Bill Rates in the United States since 1978 The nominal interest rate has declined considerably
since the early 1980s, but because expected inflation has declined as well,
the real rate has declined much less than the nominal rate.

6-2 Risk and Risk Premia
Some bonds are risky, so bond holders require a risk premium. Risk premia are determined by:
The probability of default The degree of risk aversion of bond holders
Figure 6-3 shows Yields on 10-Year U.S. Government Treasury, AAA, and BBB Corporate
Bonds, since 2000 It illustrates the impact of risk premia on
the interest rates at which different organizations could borrow. In September 2008,
the financial crisis led to a sharp increase in the rates at which firms could borrow. 6-3 The Role of Financial Intermediaries
Until now, we have looked at direct finance—borrowing directly by the ultimate borrowers from the
ultimate lenders. In fact, much of the borrowing and lending
takes place through financial intermediaries—financial institutions that receive
funds from investors and then lend these funds to others.

Figure 6-4 shows a sample commercial Bank’s
Assets, Capital, and Liabilities The Bank has Assets equal to \$100. These could be cash (reserves in the Bank’s
vault or deposits at the Fed) US Treasury Bills, loans to people or firms such as mortgages
or business loans or student loans or loans to other banks. Assets could be
more complex such as Mortgage Backed Securities which are essentially packages of different
kinds of Mortgages bundled together. These assets are less liquid than US Treasury
Bills. They would be harder to sell in case the Bank
needed to raise cash quickly. Bank has Liabilities equal to \$80. These may be the demand deposits that customers
hold or money that the bank has borrowed from other banks. Capital is the difference between Assets and
Liabilities. This bank has capital equal to \$20. If Liabilities become greater than
Assets the Bank would be insolvent. Capital ratio (the ratio of capital to assets)
= 20/100 = 20% Leverage ratio (the ratio of assets to capital)
= 100/20 = 5 A higher leverage ratio implies a higher expected
profit rate, but also implies a higher risk of insolvency and bankruptcy. The lower the liquidity of bank assets means
the more difficult they are to sell, the higher the risk of being sold at fire sale
prices (prices far below the true value) and the risk that the bank becomes insolvent. The higher the liquidity of the liabilities
(e.g., checkable or demand deposits), the higher the risk of fire sales, and the risk
that the bank becomes insolvent and thus faces
bank runs. FOCUS: Bank Runs
The U.S. financial history up to the 1930s is full of bank runs, as seen in the classic
movie It’s a Wonderful Life. One potential solution to bank runs is narrow
banking, which restricts banks from making loans, and to hold liquid and safe
government bonds. To limit bank runs, the United States introduced
federal deposit insurance in 1934. The Fed also implemented liquidity provision
so that banks could borrow overnight from other financial institutions.

6-4 Extending the IS-LM
Now we extend the IS-LM to reflect the distinction between:
• the nominal interest rate and the real interest rate
• the policy rate set by the central bank and the interest rates faced by borrowers
Note: 1. the interest rate that enters the IS relation
is the real interest rate given by the difference between the nominal
interest rate, i and the expected inflation rate ?e
2. the interest rate that matters for borrowers
is the real interest rate plus the risk premium, x. The Central bank
chooses the real policy rate, r. The interest rate faced by borrowers which
determines Aggregate Demand in the economy is
dependent on the expected inflation ?e and the risk premium x which enter the IS relation. After the Financial Crisis the Role of Risk
Premia has become evident. The central bank now chooses the real policy
rate r, which enters the IS equation as part of the
borrowing rate (r + x) for consumers and firms. Equation 6.5 shows the IS Relation
with Investment being dependent on Y and r+x.

Equation 6.6 shows the new LM relation in
terms of the Real Interest Rate. Figure 6-5 shows the effect of financial shock
on equilibrium output. Increase in x, risk premium, leads to a shift
of the IS curve to the left from IS to IS’ and a decrease in equilibrium output from
Y to Y’. Figure 6-6 shows how monetary policy can be
used to counter the effects of an increase in the risk premium
If sufficiently large, a decrease in the policy rate can in principle offset the effect of
an increase in the risk premium. The zero lower bound may however put a limit
on the decrease in the real policy rate. 6-5 From a Housing Problem to a Financial
Crisis Figure 6-7 shows the behavior of US Housing
Prices since 2000. The increase in housing prices from 2000 to
2006 was followed by a sharp decline thereafter The 2000s were a period of unusually low interest
rates, which stimulated housing demand.

Mortgage lenders was increasingly willing
to make loans to risky borrowers with subprime mortgages, or subprimes. From 2006 on, many home mortgages went underwater
(when the value of the mortgage exceeded the value of the house). Lenders faced large losses as many borrowers
defaulted. Banks were highly leveraged because:
Banks probably underestimated the risk, Bank managers had incentives to go for high
expected returns without fully taking the risk of bankruptcy into account
Banks avoided financial regulations with structured investment vehicles (SIVs)
Banks created new products through Securitization which is the creation of securities based
on a bundle of assets, such as mortgage-based securities (MBS)
Senior securities have first claims on the return from the bundle of assets; junior securities,
such as collateralized debt obligations (CDOs), come after.

Securitization was a way of diversifying risk,
but it came with costs: The bank that sold the mortgage had few incentives
to keep the risk low Even for toxic assets, the risk is difficult
for rating agencies to assess Wholesale funding is a process in which banks
rely on borrowing from other banks or investors to finance the purchase of
their assets. In 2000s, SIVs were entirely funded through
wholesale funding. Wholesale funding resulted in liquid liabilities. Figure 6-8 shows U.S. Consumer and Business
Confidence, 2007?2011 The financial crisis led to a sharp drop in
consumer and business confidence from 2007 to 2009 which in turn affected output
It bottomed in early 2009. The demand for goods decreased due to the
high cost of borrowing, lower stock prices, and lower confidence. The IS curve shift to the left. Policy makers responded to this large decrease
in demand with Financial Policies, Monetary Policy and Fiscal Policy
Financial Policies: Federal deposit insurance was raised from
\$100,000 to \$250,000, The Fed provided widespread liquidity to the
financial system through liquidity facilities, and increased the number of
assets that could serve as collateral, The government introduced the Troubled Asset
Relief Program (TARP) Monetary policy:
The federal funds rate was down to zero by December 2008.

The Fed also used unconventional monetary
policy, which involved buying other assets as to directly affect the rate
faced by borrowers. Fiscal Policy:
The American Recovery and Reinvestment Act was passed in February 2009, calling for \$780
billion in tax reductions and spending increases
Figure 6-9 shows the impact of the financial crisis and the use of financial, fiscal and
monetary policies to stabilize the economy. The financial crisis led to a shift of the
IS curve to the left from IS to IS’.

Economy moved from point A to B.
Financial and fiscal policies led to some shift back of the IS curve to the right from
IS’ to IS’’ Monetary policy led to a shift of the LM curve
down from LM to LM’. Economy moved from point B to A’. Policies were not enough, however, to avoid
a major recession. Economy went from point A before the recession
to point B as a result of the financial crisis. Expansionary fiscal and monetary policies
along with financial measures moved the economy to
point A’ where output, Y’, is smaller than the output (Y) at point A (before the
crisis)..