Essentials of Economics Study Set 12

Business

Quiz 18 :

Saving, Investment, and the Financial System

Quiz 18 :

Saving, Investment, and the Financial System

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If the business community becomes more optimistic about the profitability of capital, the _________ curve for loanable funds would shift, driving the equilibrium interest rate _________.
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Effect of increase in demand for money :
In an economy, business community is more optimistic about the profitability of capital in the market. Hence, the business men are willing to invest more; as a result, demand for loanable fund will increase and cause the demand curve to shift outward.
The rate of interest will go up to remove the disequilibrium in the money market occurred due to money demand exceeded money supply. At a higher interest rate, demand for money will reduce and supply of loanable fund will increase.
Thus, the option 'c' is correct.

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If a popular TV show on personal finance convinces more Americans about the importance of saving for retirement, the _________ curve for loanable funds would shift, driving the equilibrium interest rate _________.
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Effect of increase in saving:
A TV show insists the Americans to opt for saving; this leads the money supply to increase. The excess supply of money caused rightward shift in the supply of loanable fund curve; as a result, disequilibrium occurs in the market.
As the money supply is higher than the demand for money, the rate of interest falls down to restore equilibrium in the money market.
Thus, the option 'c' is correct.

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Three students have each saved $1,000. Each has an investment opportunity in which he or she can invest up to $2,000. Here are the rates of return on the students' investment projects: img a. If borrowing and lending is prohibited, so each student uses only personal saving to finance his or her own investment project, how much will each student have a year later when the project pays its return? b. Now suppose their school opens up a market for loanable funds in which students can borrow and lend among themselves at an interest rate r. What would determine whether a student would choose to be a borrower or lender in this market? c. Among these three students, what would be the quantity of loanable funds supplied and quantity demanded at an interest rate of 7 percent? At 10 percent? d. At what interest rate would the loanable funds market among these three students be in equilibrium? At this interest rate, which student(s) would borrow and which student(s) would lend? e. At the equilibrium interest rate, how much does each student have a year later after the investment projects pay their return and loans have been repaid? Compare your answers to those you gave in part (a). Who benefits from the existence of the loanable funds market-the borrowers or the lenders? Is anyone worse off?
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(a) Since each of the students have saved $1,000 which is used to finance one's own investment project and given the rates of return on the student's investment projects, Harry's returns at the end of the year
img Ron's returns at the end of the
img Hermione's returns at the end of the year
img (b) The comparison between each student's rate of return (interest rate which they receive) and the interest rate r determines whether a student would choose to be a borrower or lender in the market. If student's rate of return is greater than r , the student will choose to be a borrower and if student's rate of return is lesser than r , the student will choose to be a lender.
(c) At an interest rate of 7%, only Harry will be willing to lend his savings of $1,000 because his rate of return that is 5% is less than 7%. So the quantity supplied of loanable funds is $1,000.
But since Ron's and Hermione's rate of return - that is 8% and 20%, is more than 7%, each one will prefer to borrow. It is given that each student can invest up to $2,000 while each one's savings is $1,000.
So Ron and Hermione, each one will demand an excess amount of $1,000 ($2,000 - $1,000) at 7%. Thus the quantity demanded of loanable funds is $2,000 ($1,000 +$1,000).
img Similarly at 10% rate of interest both Harry and Ron are willing to lend and only Hermione is ready to take the loan.
img (d) We can say the loanable funds market is in a state of equilibrium when the quantity demanded and quantity supplied of loanable funds are equal. In our case it is 8% interest rate. Because, at 8% rate of interest Ron is neither willing to lend nor willing to take the loan. Harry is willing to lend all of his $1,000 and Hermione is willing to take a loan of $1,000. So, the demand equals to supply. Hence, we can say it is a state of equilibrium.
(e) The equilibrium interest rate is 8%. The amount a person is having at the end of the year are as follows:
Harry: At 8% interest rate he will lend all his money. So the amount he will have is the initial amount and the interest he earned on it.
That is,
img Ron: At 8% interest rate he will neither lend not take any loan. So the amount he will have is the initial amount and the returns from investment in the project.
That is,
img Hermione: At 8% interest rate he will take a loan of $1,000 which is his requirement to maximize his earnings. So the amount he will have is the initial, the loan amount and the returns from investment in the project after paying the interest on loan.
That is,
img Comparing the answers to that of part (a) reveals that Harry, the lender gets benefit because he gets $30 ($1080 - $1050) from the loanable market. Similarly, Hermione, the borrower also gets the benefit because he gets $200 ($1,320 -$1,120) from the loanable market. So both Harry and Hermione get the benefit from the market. Nobody is worse off from the market. Ron is neither better off nor worse off from the market.

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Suppose GDP is $8 trillion, taxes are $1.5 trillion, private saving is $0.5 trillion, and public saving is $0.2 trillion. Assuming this economy is closed, calculate consumption, government purchases, national saving, and investment.
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From 2008 to 2012, the ratio of government debt to GDP in the United States
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Nina wants to buy and operate an ice-cream truck but doesn't have the financial resources to start the business. She borrows $5,000 from her friend Max, to whom she promises an interest rate of 7 percent, and gets another $10,000 from her friend David, to whom she promises a third of her profits. What best describes this situation?
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What is investment? How is it related to national saving in a closed economy?
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Describe a change in the tax code that might increase private saving. If this policy were implemented, how would it affect the market for loanable funds?
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What is a government budget deficit? How does it affect interest rates, investment, and economic growth?
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Explain the difference between saving and investment as defined by a macroeconomist. Which of the following situations represent investment? Saving? Explain. a. Your family takes out a mortgage and buys a new house. b. You use your $200 paycheck to buy stock in AT T. c. Your roommate earns $100 and deposits it in his account at a bank. d. You borrow $1,000 from a bank to buy a car to use in your pizza delivery business.
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Why is it important for people who own stocks and bonds to diversify their holdings? What type of financial institution makes diversification easier?
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Economists in Funlandia, a closed economy, have collected the following information about the economy for a particular year: Y = 10,000 C = 6,000 T = 1,500 G = 1,700 The economists also estimate that the investment function is: I = 3,300 2 100 r , where r is the country's real interest rate, expressed as a percentage. Calculate private saving, public saving, national saving, investment, and the equilibrium real interest rate.
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Suppose the government borrows $20 billion more next year than this year. a. Use a supply-and-demand diagram to analyze this policy. Does the interest rate rise or fall? b. What happens to investment? To private saving? To public saving? To national saving? Compare the size of the changes to the $20 billion of extra government borrowing. c. How does the elasticity of supply of loanable funds affect the size of these changes? d. How does the elasticity of demand for loanable funds affect the size of these changes? e. Suppose households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future. What does this belief do to private saving and the supply of loanable funds today? Does it increase or decrease the effects you discussed in parts (a) and (b)?
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Suppose that Intel is considering building a new chipmaking factory. a. Assuming that Intel needs to borrow money in the bond market, why would an increase in interest rates affect Intel's decision about whether to build the factory? b. If Intel has enough of its own funds to finance the new factory without borrowing, would an increase in interest rates still affect Intel's decision about whether to build the factory? Explain.
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In the summer of 2010, Congress passed a far-reaching financial reform to prevent another financial crisis like the one experienced in 20)8-2009. Consider the following possibilities: a. Suppose that, by requiring firms to comply with strict regulations, the bill increases the costs of investment. On a well-labeled graph, show the consequences of the bill on the market for loanable funds. Be sure to specify changes in the equilibrium interest rate and level of saving and investment. What are the effects of the bill or long-run economic growth? b. Suppose, on the other hand, that by effectively regulating the financial system, the bill increases savers' confidence in the financial system. Show the consequences of the policy in this situation on a new graph, again noting changes in the equilibrium interest rate and level cf saving and investment. Again evaluate the effects on long-run growth.
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Many workers hold large amounts of stock issued by the firms at which they work. Why do you suppose companies encourage this behavior? Why might a person not want to hold stock in the company where he works?
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What is the role of the financial system? Name and describe two markets that are part of the financial system in the U.S. economy. Name and describe two financial intermediaries.
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A closed economy has income of $1,000, government spending of $200, taxes of $150, and investment of $250. What is private saving?
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If the government collects more in tax revenue than it spends, and households consume more than they get in after-tax income, then
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What is national saving? What is private saving? What is public saving? How are these three variables related?
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