Ch 22 Problems & Questions

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?

Firms encourage their workers to hold large amounts of stock because it gives employees an incentive to care about how profitable the firm is doing rather than just caring about their own salary. A person might not want to hold stock in the company where he/she works if the stock market crashes or if the value of the firm decreases. A worker's salary is dependent on the firm's performance as a whole rather than solely an individual's performance, which is risky.

Three students have each saved $1000. Each has an investment opportunity in which he or she can invest up to $2000. Here are the rates of return on the students' investment projects: Harry 5% Ron 8% Hermione 20% If borrowing and lending are 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?

Harry $1050 Ron $1080 Hermione $1200

What would you need to know about private saving to judge which of these two policies, reduction of taxes on private saving and reduction of the government budget deficit, would be a more effective way to raise investment?

you'd need to know how responsive private saving is to tax cuts

Suppose the government borrows $20 billion more next year than this year. Suppose households believe that greater gov. borrowing today implies higher taxes to pay off the government debt in the future. What does this believe do to private saving and the supply of loanable funds today? Does it increase or decrease the effects you discussed in part (a) and (b)?

This will imply that households will reduce consumption to increase private saving as well as the supply of loanable funds. This will counterbalance the reduction in public saving and interest rates.

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?

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.

What is a government budget deficit? How does it affect interest rates, investment, and economic growth?

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.

Three students have each saved $1000. Each has an investment opportunity in which he or she can invest up to $2000. Here are the rates of return on the students' investment projects: Harry 5% Ron 8% Hermione 20% Among these three students, what would be the quantity of loanable funds supplied and quantity demanded at interest rate of 7%? At 10%?

If r=7% then Ron and Hermione would demand loanable funds and Harry would supply loanable funds. If r=10% then Hermione would demand loanable funds and Ron and Harry would supply loanable funds.

Which bond would you expect to pay a higher interest rate: a bond from Coca-Cola or a bond from a software company you run in your garage?

a bond from a software company you run in your garage would pay a higher interest rate because there is more credit risk

Which bond would you expect to pay a higher interest rate: a bond issued by the federal government or a bond issued by New York State?

a bond issued by the federal government would pay a higher interest rate because an investor does not have to pay federal income tax on the bond from New York State

Which bond would you expect to pay a higher interest rate: a bond of the US government or a bond of an Eastern European government?

a bond of an Eastern European government would pay a higher interest rate because there is a greater risk of default

Which bond would you expect to pay a higher interest rate: a bond that repays the principal in year 2020 or a bond that repays the principal in year 2040?

a bond that repays the principal in year 2040 would pay a higher interest rate because they have a longer term to maturity.

Suppose that Intel is considering building a new chipmaking factory. 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?

an increase in interest rates would probably hinder Intel's decision about building a factory because the cost of borrowing money now becomes higher.

What is investment? How is it related to national saving in a closed economy?

Investment is equal to national saving.

Why is it difficult to implement a reduction of taxes on private saving and reducing the government budget deficit?

When taxes on private saving fall, the government revenue is also likely to fall, increasing the government budget deficit.

Suppose that Intel is considering building a new chipmaking factory. 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 a factory? Explain.

Yes because there is an opportunity cost on the use of the funds. Intel will compare its potential returns from building the factory to the potential return from the bond market. If interest rates rise, so that bond market returns rise, Intel is again less likely to invest in the factory.

Funlandia, a closed economy, has the following info about the economy for a particular year: Y=10,000 C=6000 T=1500 G=1700 The economists also estimate that the investment function is: I=3300-100r 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.

equilibrium interest rate=10% private saving=$2500 public saving=$-200 national saving=$2300 investment=$2300

What is national saving? What is private saving? What is public saving? How are these three variables related?

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

Three students have each saved $1000. Each has an investment opportunity in which he or she can invest up to $2000. Here are the rates of return on the students' investment projects: Harry 5% Ron 8% Hermione 20% At what interest rate would the loanable funds market among these students be in equilibrium? At this interest rate, which student(s) would borrow and which student(s) would lend?

r=8% would be the equilibrium interest rate. At this interest rate, Harry would lend, Hermione would borrow, and Ron would neither borrow nor lend.

Explain the difference between saving and investment as defined by a macroeconomist. Does your roommate's earnings and deposit of $100 represent saving or investment?

saving because he is setting his money away to buy consumption goods at a later time.

Explain the difference between saving and investment as defined by a macroeconomist. Does using your $200 paycheck to buy stock in AT&T represent saving or investment?

saving because you are not spending your money consumption goods

Suppose the government borrows $20 billion more next year than this year. 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.

Because interest rates increase, investment and national saving decrease and private saving increases. The increase in government borrowing decreases public saving. The quantity of loanable funds decreases by less than $20 billion, while public saving declines by $20 billion and private saving rises by less than $20 billion.

Suppose the government borrows $20 billion more next year than this year. How does the elasticity of supply of loanable funds affect the size of these changes?

If the supply of loanable funds is more elastic, the flatter the slope of the supply curve will be, which means interest rates would rise less and less so the national saving would fall more.

What is the role of the financial system? Name and describe two markets that are part of the financial system in the US economy. name and describe two financial intermediaries.

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.

Suppose the government borrows $20 billion more next year than this year. Use a supply-and-demand diagram to analyze this policy. Does the interest rate rise or fall?

Supply shifts to the left from S to S', which causes interest rates to rise.

Explain the difference between saving and investment as defined by a macroeconomist. Does borrowing $1000 from a bank to buy a car to use in your pizza delivery business represent saving or investment?

investment because you are spending your money on physical capital that will increase productivity in the long run

Suppose GDP is $8 trillion, taxes are $1.5 trillion, private saving is $0.5 trillion, and public saving is $0.2 trillion. Assuming the economy is closed, calculate consumption, government purchases, national saving, and investment.

investment=$0.7 trillion national saving=$0.7 trillion consumption=$6 trillion government purchases=$1.3 trillion

Why is it important for people who own stocks and bonds to diversify their holdings? What type of financial institution makes diversification easier?

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.

Three students have each saved $1000. Each has an investment opportunity in which he or she can invest up to $2000. Here are the rates of return on the students' investment projects: Harry 5% Ron 8% Hermione 20% 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?

harry will have 1000(1.08)=1080 Ron will have 1000(1.08)=1080 Hermione will have 2000(1.2)-1000(1.08)=2400-1080=1320. Both borrowers and lenders benefit from the existence of the loanable funds market.

Explain the difference between saving and investment as defined by a macroeconomist. Does your family taking out a mortgage and buying a new house represent investment or saving?

investment because a new house is the purchase of new physical capital

Three students have each saved $1000. Each has an investment opportunity in which he or she can invest up to $2000. Here are the rates of return on the students' investment projects: Harry 5% Ron 8% Hermione 20% 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 a lender in this market?

If the expected rate of return is greater than r, the student would borrow. If the expected rate of return is less than r, the student would lend.