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Graphically (using the IS-LM model) illustrate and explain what effect an increase in default-risk premium (x)...

Graphically (using the IS-LM model) illustrate and explain what effect an increase in default-risk premium (x) will have on the equilibrium output. How can we restore teh output to its original level following this change?

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Answer #1
  • Increase in Default risk would lead to the fall in amount of loan being lent. Now financial institutions would not be ready to fund business projects. Thus, output would fall in economy and unemployment would rise up.

Following shall be shape of IS-LM curve:

In above diagram LM curve shifts to left thereby increasing interest rate and decreasing output level.

  • Now government must either increase expenditure in economy or increase money supply to reach previous equilibrium level.
  • Government expenditure will leads to shift in IS curve to right and new equilibrium will be established.
  • Further, increase in money supply by reducing Federal fund rate would also increase money supply which would lead to shift in LM curve to right and it shall restore previous equilibrium.
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