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Unformatted text preview: , where
i is the expected return on the risky asset and i is the rate that the intermediary
must pay on its debt. Thus the acceptable leverage ratio, and correspondingly the
maximum value of assets that the intermediary can acquire, will be an increasing
function of the credit spread.
The IS–MP Model with Credit Frictions
The equilibrium credit spread and volume of credit shown in Figure 3A are
determined for a particular value of national income Y ; because the schedules LS
and LD depend on Y, as shown in Figure 2A, the location of the schedule XD (at
least) in Figure 3B also depends on Y. For reasons already discussed above, a higher
level of Y should shift LS to the right and LD to the left, and each of these effects
results in a lower equilibrium value of the rate i s paid to savers, for any given position
of the schedule XS. Hence we can once again derive an IS schedule, indicating the
equilibrium value of i s for any assumed level of income Y, but now the IS schedule
will also include a given assumption about the supply of intermediation.7
The resulting model makes many of the same qualitative predictions about the
effects of economic disturbances or policy chang...
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