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.

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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

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.