Answer to Question #180467 in Macroeconomics for Eth

Question

Consider the loanable funds market in a closed economy. Suppose that, in addition to the risk-free rate, r, firms are required to pay a risk premium, m, that reflects the economy- wide (i.e. systemic) risk of default, when they borrow so that the demand for loanable funds is described by I(r+m) while the supply is S(r) as usual. Analyze the effects on the quantity of saving and investment, on GDP, and on the risk-free interest rate, of a permanent rise in systemic risk modeled as a rise in m. What happens to the borrowing cost, r + m, that firms pay in this circumstance?

Answer 1

effects on the quantity of saving and investment, on GDP, and on the risk-free interest rate, of a permanent rise in systemic risk modeled as a rise in m. 

It will give rise to risks

Discussed below

There various type of risks

Systematic risk

is that part of the total risk that is caused by factors beyond the control of a specific company or individual.

Systematic risk is caused by factors that are external to the organization.

Systematic risk cannot be diversified away by holding a large number of securities.

Market risk

Thisis caused by the herd mentality of investors,

i.e. the tendency of investors to follow the direction of the market.

Market price changes are the most prominent source of risk in securities.

Interest rate risk

These arises due to changes in market interest rates.

In the stock market, this primarily affects fixed income securities because bond prices are inversely related to the market interest rate. I

interest rate risks include two opposite components: Price Risk and Reinvestment Risk.

Both of these risks work in opposite directions. 

These all will affect the borrowing cost.