Chapter 6: The Extended IS-LM Model - Exam Flashcards

A collection of flashcards covering key concepts from Chapter 6 of the Extended IS-LM Model.

Nominal Interest Rate

Interest in terms of dollars (what you see at the bank).

Real Interest Rate

Interest in terms of a basket of goods (your actual purchasing power).

Fisher Equation Approximation

The equation r = i - pi^e, where Real rate equals Nominal rate minus Expected Inflation.

Risk Premium (x)

The additional interest a borrower pays to compensate the lender for the risk of default.

Factors Determining Risk Premium (x)

1. Probability of default. 2. Degree of risk aversion of bond holders.

Policy Rate

The rate set by the Fed on the LM curve in the extended IS-LM model.

Borrowing Rate

The rate on the IS curve, which includes the risk premium (r + x).

Bank Capital Calculation

Capital = Assets - Liabilities; it represents the owners' stake in the bank.

Capital Ratio

Capital / Assets; measures how much capital banks have compared to their assets.

Leverage Ratio

Assets / Capital; indicates how much debt a bank is using to finance its assets.

Trade-off of High Leverage Ratio

Increases expected profit rate but also increases the risk of insolvency and bankruptcy.

Insolvency

A situation where Assets < Liabilities; the bank is considered broke.

Illiquidity

The condition where a bank has assets but can't sell them fast enough for cash.

Zero Lower Bound (ZLB)

The principle that the nominal interest rate cannot go below zero, limiting the Fed's policy options.

Unconventional Monetary Policy

When the Fed buys assets directly to lower the risk premium when policy rates can't be lowered further.

Securitization

The process of bundling loans into a single security to diversify risk.

Toxic Assets

Securitized assets that became unsellable during the 2008 crisis due to complexity.

Wholesale Funding

When banks borrow short-term from other banks/investors instead of relying primarily on deposits.

Fire Sale

When a bank sells assets at extremely low prices to obtain cash, harming the value of similar assets.

Vicious Cycle of the 2008 Crisis

Falling house prices lead to lower bank capital, reduced lending, lower output, and increased panic.