An increase in the default premium
A) raises the safe credit market interest rate.
B) lowers the real interest rate and firms invest more.
C) shifts the optimal investment schedule to the left.
D) shifts the optimal investment schedule to the right.
E) will prevent firms from defaulting on their loans.

Question

Quizplus · Accepted Answer

An increase in the default premium means that lenders perceive borrowers as more risky, and therefore demand a higher interest rate to compensate for the higher probability of default. This increases the cost of borrowing for firms, shifting the optimal investment schedule to the left as firms will reduce investment to adjust for the higher borrowing costs. Therefore, choice C is the correct answer.

An Increase in the Default Premium