Suppose that a collapse of housing and stock prices reduces real wealth. That reduction in real wealth reduces autonomous planned spending by 800 billion at every interest rate.
(a) Derive the new equations for autonomous planned spending, Ap, and the IS curve, Y = kAp. Graph the new IS curve for interest rates between 0 and 8, with intervals of one-half of a percentage point.
(b) Use the graph of the new IS curve and the graphs of the three LM curves from part (d) of problem 1 to explain what the new equilibrium interest rates are for the federal funds rate, the government bond rate, and the private bond rate and what the new equilibrium level of income is.
(c) Suppose that the collapse of housing and stock prices creates a crisis in financial markets and that the risk premium increases from 2 percentage points to 3 percentage points. Explain why the financial crisis would lead to a rise in the risk premium.
(d) Use the new risk premium to graph the new LM curve for the private bond rate for interest rates between 0 and 8, with intervals of one-half of a percentage point.
(e) Use the graph of the new LM curve for the private bond rate, together with the IS curve from part (a) of this problem and the LM curve for the private bond rate, to explain how the financial crisis affects the equilibrium private bond rate and the equilibrium level of income.