Focus on extending the ISLM model along two dimensions: nominal vs. real interest rates and credit spreads.
Importance of understanding these concepts for the upcoming quiz and overall comprehension.
1. Nominal vs. Real Interest Rates
Definition
Nominal Interest Rate (i): The stated interest rate in terms of dollars (e.g., 10% on a bond).
Real Interest Rate (r): The interest rate in terms of a basket of goods, adjusted for inflation.
Key Points
Historically, the assumption was no inflation (fixed prices), leading to no distinction between nominal and real rates. However, inflation is typically positive.
Impact of Inflation: When inflation is expected to be nonzero, the real interest rate will differ from the nominal interest rate.
Importance of Real Interest Rate
Real rates impact private sector decisions, especially regarding investment in physical assets.
Investment decisions focus on the real rate since that reflects the true cost of borrowing adjusted for future inflation.
Calculation of Real Interest Rate
Derived from nominal interest rate and expected inflation:
( r \approx i - \text{Expected Inflation} )
2. Credit Spreads
Definition
Credit Spread (X): The difference between the interest rate on risky corporate bonds and the risk-free rate (e.g., U.S. Treasury bonds).
Key Points
Corporate bonds typically carry risk, requiring a premium over the risk-free rate due to potential default risk.
Increased credit spreads during financial crises and economic downturns reflect heightened risk perception.
Factors Influencing Credit Spread
Probability of Default (P): Higher perceived risk leads to higher credit spreads.
Risk Aversion: Investors may require higher compensation for holding riskier assets during uncertain times.
3. Integrating Extensions into the ISLM Model
Modifications
Investment Function: Now depends on real interest rates adjusted for credit risk (X) rather than just nominal rates.
Introduced parameters for expected inflation and credit spreads into equilibrium analysis.
Economic Implications
When expected inflation rises or credit spreads decrease, it acts similarly to an expansionary monetary policy, shifting the ZZ curve upward.
Conversely, during economic downturns (e.g., Great Recession), rising credit spreads and falling expected inflation shift the IS curve inward, reducing investment.
4. Historical Context and Recent Events
2008 Financial Crisis: Notable shift in real vs. nominal interest rates, with real rates surpassing nominal rates due to plummeting expected inflation.
COVID-19 Pandemic: Initial drop in interest rates, rapid recovery of expected inflation, and rising credit spreads.
Current Situation: Challenges for the FED as nominal rates rise but real rates do not keep pace due to fluctuating expected inflation and credit spreads.
FED’s Response Strategies
Large Scale Asset Purchases: The FED engaged in purchasing corporate bonds to stabilize financial markets and reduce credit spreads during crises.
Effects on Financial Conditions: Central banks aim to lower borrowing costs for corporations, impacting overall economic activity.
Conclusion
Understanding the distinction between nominal and real interest rates, alongside credit spreads, is crucial for comprehending macroeconomic dynamics and the ISLM model's applications.
These extensions provide a more realistic framework for analyzing economic conditions and the impact of monetary policy.