1. Corporate bond interest rates are a good measure of the interest rate facing
ID: 1171329 • Letter: 1
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1. Corporate bond interest rates are a good measure of the interest rate facing firms planning investments. Before the financial crisis, this rate was about 2% higher than the fed funds rate. At the peak of the crisis in October 2008, the Baa rated bond rate was almost 9 percent higher than the fed funds rate. a) Go to the FRED database and look up the series BAAlOY and extend the data range to "max". Compare what you see to the TED spread TEDRATE for the same range. Find the definitions for each of these interest rate spreads. Why do you think these two measures are often used to discuss financial conditions in the macroeconomy? b) Suppose the economy begins in steady state, and there is a shock to the interest spread f. Use the IS- MP and AS/AD diagrams to show and explain how the economy reacts if the Fed follows the simple monetary rule does not change its inflation target. c Continuing from part b), explain how the economy adjusts back towards the steady state when the shock to f lasts for one period.Explanation / Answer
a. BAA10Y is the spread between Moody's Seasoned Baa Corporate Bond & 10-Year Treasury Constant Maturity while TED spread TEDRATE is the spread between 3 month LIBOR and 3 month Treasury Bill.
TED spread refers to the diffrence between what investors charge for investing in large bank vs what they charge for investing in goverment traesuries. Thus as TED spread increases it can be a signal that interbank loans are increasingly becoming credit risky. Macroeconomically, an increasing TED spread would mean that economy is performing poorly with poor investor confidence in banks.
On a similar terms the BAA10Y spread also gives us insight into the firm wide economy stress. It could further indicate that there is much illiquidity in the market and hence possibility of a recession market with high probability of default expected
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