QUESTIONS FOR REVIEW

1. The financial system helps match one person's saving with another person's
investment. Two markets that are part of the financial system in the US
economy are the bond and stock market. Bonds are certificates of
indebtedness, whereas stocks are partial ownerships of a firm. Two financial
intermediaries are banks and mutual funds. Banks take in deposits from
people who want to save to make loans to people who want to borrow. Mutual
funds sell shares to the public and use the proceeds to buy stocks and bonds.
2. It is important for people who own stocks and bonds to diversify their holdings
because then they will have only a small stake in each asset, which reduces
risk. Mutual funds make such diversification easy by allowing a small investor
to purchase parts of hundreds of different stocks and bonds.
3. National saving is equal to investment. private saving is the income
households have left after paying taxes and consumption. public saving is the
tax revenue the government has after paying for its spending. Public + private
saving = national saving
4. Investment is equal to national saving.
5. A change in the tax code that might increase private saving is the expansion
of eligibility for special accounts that allow people to shelter some of their
saving from taxation. This would increase the supply of loanable funds, lower
interest rates, and increase investment.
6. A government budget deficit occurs when government spending is greater
than tax revenue, which causes interest rates to increase, investment to
decrease, and economic growth to decrease.
 PROBLEMS AND APPLICATIONS
1.
a. The bond of the U.S government pays higher interest rate because more stable
economies have higher interest rates on their bonds.
b. The bond that repays the principal in the year 2020 pays higher interest rate
because the shorter the time is, the higher the rate is.
c. The bond from coca pays higher because there is more potential for Coca to grow
than the software company to grow. Coca is a much more stable and profitable
enterprise than a software firm run in the garage.
d. NY bonds have higher interest rate
2. Companies encourage their employees to hold stock in the company because it
gives the workers the incentive to care about the firm’s profit and to work hard. In
order to raise the value of their stock, employees will contribute more for the
company.
But from the standpoint of employees’ view, owning stock in the company where
they work can be risky. Their wages are already tied to how well the firm performs.
If the firm has troubles, their wages will be reduced.
3. To a macroeconomist, saving occurs when a person’s income exceeds his
consumption, whereas investment occurs when a person or a firm purchases new
capital, such as a house or a business equipment. a. Investment because it is a
purchase of a new capital. b. Saving because your income of $200 is not being spent
on consumption goods. c. Saving because the money is not spent on consumption
goods. d. Investment because the car is a capital good.
4.
Sprivate = Y – T – C
0.5 = 8 – 1.5 – C
C =6
Hence, the national consumption is $6 trillion.
Spublic = T – G
0.2 = 1.5 – G
G = 1.3
Hence, the government purchases are $1.3 trillion.
Since Investment = national saving = Sprivate + Spublic = 0.5 + 0.2 = 0.7
Hence, the national investment is $0.7 trillion.
5. Sprivate = Y – T – C = 10000 – 1500 – 6000 = 2500
Spublic = T – G = 1500 – 1700 = -200
I = Sprivate + Spublic = 2500 -200 = 2300
Since, I = 3300 – 100r
2300 = 3300 – 100r
r = 10
Finally, the equilibrium real interest rate is 10%.
6.
a. An increase in the interest rate discourages Intel Company to build a new chip-
making factory. Bonds are financial instruments through which accompany can
borrow from the public. When a company borrows funds from public in the bond
market, it has to give interest rate periodically. Paying interest rate is just of
borrowing. When interest rates increase the cost of borrowing for the company
increases. So bonds become an expansive financial instrument. The returns from the
new factory may not be sufficient to cover the cost of borrowing- thus Intel Company
is discouraged to build a new factory.
b. Yes, an increase in interest rates will discourage the company to build a new chip
factory even if the company decides to finance its project through its own resources.
This is so because high interest rates make the bond market attractive for the
company to invest in it. The expected returns from bond market will more than the
expected returns from the newly build factory. So relatively bond market becomes
more lucrative and profitable. So, high interest rates divert the company funds from
building new factory to bond market.
7.
a. Harry will have: $1000(1 + 0.05) = $1200 Ron will have: $1000(1 + 0.08) = $1080
Hermione will have: $1000(1 + 0.20) = $1200
b. If the expected return rate is greater than r, the student would borrow. If the
expected rate of return is less than r, the student would lend.
c. If r = 7%, Harry would want to lend while Ron and Hermione would want to
borrow. The quantity of funds demanded would be $2000, while the quantity
supplied would be $1000. If r = 10%, only Hermione would want to borrow. The
quantity of funds demanded would be $1000, while the quantity supplied would be
$2000.
d. The loanable funds market would be in equilibrium at an interest rate of 8%. Harry
would want to lend, and Hermione would want to borrow. Ron would want to neither
lend nor borrow. Thus, the quantity demanded = quantity supplied = $1000.
e. Harry will have $1000(1 + 0.08)= $1080 Ron will have $1000(1 + 0.08) = $1080
Hermione will have : $2000(1 + 0.2) - $1000(1 + 0.08) = $1320 Thus, Harry and
Hermione-both lender and borrower will be better off. No one is worse off.
8.
a. Figure 1 (below) illustrates the effect of the $20 billion increase in government
borrowing. Initially, the supply of loanable funds is curve S1, the equilibrium real
interest rate is i1, and the quantity of loanable funds is L1. The increase in
government borrowing by $20 billion reduces the supply of loanable funds at each
interest rate by $20 billion, so the new supply curve, S2, is shown by a shift to the
left of S1 by exactly $20 billion. As a result of the shift, the new equilibrium real
interest rate is i2. The interest rate has increased because of the increase in
government borrowing.
b. Because the interest rate has increased, investment and national saving decline
and private saving increases. The increase in government borrowing reduces public
saving. From the figure you can see that total loanable funds (and thus both
investment and national saving) decline by less than $20 billion, while public saving
declines by $20 billion and private saving rises by less than $20 billion.
c. If households believe that greater government borrowing today implies higher
taxes to pay of the government debt in the future, then people will save more so they
can pay the higher future taxes. Thus, private saving will increase, as will the supply
of loanable funds. This will offset the reduction in public saving, thus reducing the
amount by which the equilibrium quantity of investment and national saving decline
and reducing the amount that the interest rate rises.
d. The elasticity of demand will also have a direct effect on the parameters mentioned
above. If the demand is more elastic, the curve will be flatter. So, when the
government borrowings increase, the interest rate will increase by less, and the
national savings will decrease. On the contrary, if the demand is less elastic, the
curve will be steeper. The impact of government borrowings will be more on the
interest rate and national savings.
e. The belief of higher taxes in the future to pay off the government debt will increase
the private savings in the economy now. The fear of paying higher taxes in the future
will encourage people to save more now so that they can manage their funds easily,
and hence, the supply will increase for the loanable funds. An increase in private
savings will compensate for the decline in public savings, and the amount of national
savings will also increase. The interest rate will also increase but at a reduced rate.
9.
a. Investment can be increased by reducing taxes on private saving or by reducing
the government budget deficit. But reducing taxes on private saving has the effect
of increasing the government budget deficit, unless some other taxes are increased
or government spending is reduced. Therefore, it is difficult to engage in both
policies at the same time.
b. To know which of these policies would be a more effective way to raise
investment, you would need to know: -(1) what the elasticity of private saving is
with respect to the after-tax real interest rate, because that would determine how
much private saving would increase if you reduced taxes on saving- (2) how private
saving responds to changes in the government budget deficit, because, for example,
if Ricardian equivalence holds, the decline in the government budget deficit would
be matched by an equal decline in private saving, so national saving would not
increase at all- (3) how elastic investment is with respect to the interest rate, because
if investment is quite inelastic, neither policy will have much of an impact on
investment.