## Quiz 18 :

Saving, Investment, and the Financial System

Answer:

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.

Answer:

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.

Answer:

(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

Ron's returns at the end of the

Hermione's returns at the end of the year

(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).

Similarly at 10% rate of interest both Harry and Ron are willing to lend and only Hermione is ready to take the loan.

(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,

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,

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,

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.