Question

Suppose the economy starts with gdp at potential, the real interest rate and the long-run marginal product of capital both equal 3 percent. a mild financial crisis hits that raises the risk premium from zero to 2 percent.

analyse the effect of this shock in the is-mp diagram

Answer 1

Increased government borrowing leads to a shift in the demand curve for financial capital, causing interest rates to rise and potentially crowding out private investment. The original equilibrium at an interest rate of 5% and 20% of GDP shifts to a new equilibrium at 6% and 21% of GDP due to greater government demand for capital.

• When government borrowing increases substantially, it impacts the supply and demand dynamics in the financial markets, specifically influencing the interest rates.
• According to the scenario provided, an original equilibrium (E) exists at an interest rate of 5% with an equilibrium quantity of financial capital equivalent to 20% of GDP.
• This equilibrium is illustrated by the intersection of the demand curve (Do) and the supply curve (So).
• As the government budget deficit increases, there is a shift in the demand curve for financial capital from Do to D₁.
• This shift represents an increased demand for capital due to government borrowing, which in turn causes the interest rate to rise from 5% to 6%.
• This change leads to a new equilibrium (E₁) with an equilibrium quantity of 21% of GDP.
• The consequential rise in interest rates is an economic mechanism that can potentially crowd out private investment, as the government's need for financial capital can decrease the amount available for private entities.