Chapter 13 non Aplia + Aplia

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.

Given that Y = 8, T = 1.5, Sprivate = 0.5 = Y -T - C, Spublic = 0.2 = T - G. -Since Sprivate = Y - T - C, then rearranging gives C = Y - T - Sprivate = 8 - 1.5 - 0.5 = 6. -Since Spublic = T - G, then rearranging gives G = T - Spublic = 1.5 - 0.2 = 1.3. -Since S = national saving = Sprivate + Spublic = 0.5 + 0.2 = 0.7. Finally, since I = investment = S, I = 0.7.

Classify each of the following based on the macroeconomic definitions of saving and investment. Alex purchases a corporate bond issued by a car company. Clancy takes out a mortgage for a new home in Detroit. Becky purchases new ovens for her cupcake-baking business. Eileen purchases stock in NanoSpeck, a biotech firm.

Saving Investment Investment Saving

Find public saving and private Saving

Sp= 220 Sg =60

Scenario 3: Initially, the government's budget is balanced; then the government significantly increases spending on national defense without changing taxes. -This change in spending causes the government to run a budget deficit, which decreases national saving. -This causes the interest rate to rise, crowding out the level of investment spending.

The government moves from a balanced budget to a budget deficit when it increases government spending without changing taxes. Recall that public saving is negative when the government runs a budget deficit. Thus, the deficit subtracts from national saving. Since saving is the source of supply in the market for loanable funds, the reduction in public saving causes the supply of loanable funds to shift to the left. There is a shortage of loanable funds at the initial interest rate. With more willing borrowers than lenders, the lenders will be able to raise the interest rate they charge for loans. As the interest rate rises, the quantity of loanable funds demanded decreases. The equilibrium interest rate rises, and the equilibrium quantity of loanable funds saved and invested falls. Crowding out is the reduction in the level of investment that occurs when the government borrows to finance a budget deficit. Thus, crowding out may occur in this scenario.

For an imaginary closed economy, T = $5,000; S = $11,000; C = $48,000; and the government is running a budget surplus of $1,000. Then a. private saving = $10,000 and GDP = $55,000. b. private saving = $10,000 and GDP = $63,000. c. private saving = $12,000 and GDP = $67,000. d. private saving = $12,000 and GDP = $69,000.

B

Suppose the interest rate is 2.5%. Based on the previous graph, the quantity of loanable funds supplied is less than the quantity of loans demanded, resulting in a shortage of loanable funds. This would encourage lenders to raise the interest rates they charge, thereby increasing the quantity of loanable funds supplied and decreasing the quantity of loanable funds demanded, moving the market toward the equilibrium interest rate of 3%

Based on the graph you are given, at the interest rate of 2.5%, the quantity of loanable funds supplied ($250 billion) is less than the quantity of loanable funds demanded ($350 billion), resulting in a shortage of loanable funds. Because of the shortage, lenders will find that they can safely increase the interest rates they charge. As they do so, the return to saving rises, and the quantity of loanable funds supplied will increase. At the same time, the higher cost of borrowing prices some borrowers out of the market, and the quantity of loanable funds demanded declines. This process continues until the interest rate reaches the equilibrium level of 3%, where the quantity of loanable funds demanded is exactly equal to the quantity of loanable funds supplied.

Suppose GDP in this country is $780 million. Enter the amount for investment. National Income Account Value Government Purchases (G) 200 Taxes (-Transfer Payments(T) 260 Consumption (C ) 300 Investment (I)

A closed economy does not trade with the rest of the world, and, thus, its net exports are zero. Therefore, in this case, GDP is the sum of consumption, investment, and government purchases. To find the missing value of investment, the national income accounting identity can be rearranged as follows: I = Y-G-C =280

In 2002 mortgage rates fell and mortgage lending increased. Which of the following could explain both of these changes? a. The demand for loanable funds shifted rightward. b. The demand for loanable funds shifted leftward. c. The supply of loanable funds shifted rightward. d. The supply of loanable funds shifted leftward.

C

In a closed economy, if Y remained the same, but G rose, T rose by the same amount as G, and C fell but by less than the increase in T, what would happen to private and national saving? a. national saving would fall and private saving would rise b. national saving would rise and private saving would fall c. both national saving and private saving would fall d. None of the above is correct.

C

Based on your calculations, the government is running a budget

surplus When a government spends less than it collects in tax revenues, it runs a government budget surplus. Public saving is positive in the case of a budget surplus. Note that national saving can be thought of as the sum of private and public saving.

National savings =

National saving is the total income in the economy that is left over after paying for consumption and government purchases. In a closed economy, subtracting consumption and government purchases from GDP also yields investment spending, so national saving equals investment: 280

Suppose Sean decides to buy 100 shares of RoboTroid stock. Which are true? -Expectations of a recession that will reduce economy-wide corporate profits will likely cause the value of Sean's shares to decline. -An increase in the perceived profitability of RoboTroid will likely cause the value of Sean's shares to rise. -The price of his shares will rise if RoboTroid issues additional shares of stock.

-Expectations of a recession that will reduce economy-wide corporate profits will likely cause the value of Sean's shares to decline. -An increase in the perceived profitability of RoboTroid will likely cause the value of Sean's shares to rise. Explination: Corporations issue stock to raise money, a practice known as equity finance. Each share of stock represents partial ownership of the company, so investors' perceptions of the company's future profitability are reflected in the price of the firm's stock. The price of a stock is determined by the forces of supply and demand. If people expect a corporation to have unusually high profits in the future, demand for the stock increases, and its share price rises. A stock index represents an average of a group of stock prices. If optimism about corporate profits is economy-wide, we would expect the major stock indexes, such as the Dow Jones Industrial Average or the Standard and Poor's 500, to increase in value. An increase in the number of shares of stock a company issues represents an increase in the supply of the shares—it will reduce the value of each share since the value of the company is thereby split into smaller units. A firm can raise money only through an initial offering of its shares. Once the shares begin trading among stockholders on organized stock exchanges (like the New York Stock Exchange), the proceeds from selling a stock accrue directly to the stockholders.

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= 3,000-100r 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.

-Private saving is equal to (Y - T - C) = 10,000 - 1,500 - 6,000 = 2,500. -Public saving is equal to (T - G) = 1,500 - 1,700 = -200. -National saving is equal to (Y - C - G) = 10,000 - 6,000 - 1,700 = 2,300. Investment is equal to saving = 2,300. The equilibrium interest rate is found by setting investment equal to 2,300 and solving for r: 3,300 - 100r = 2,300. 100r = 1,000. r = 10%.

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?

Companies encourage their employees to hold stock in the company because it gives the employees the incentive to care about the firm's profits, not just their own salaries. Then, if employees see waste or see areas in which the firm can improve, they will take actions that benefit the company because they know the value of their stock will rise as a result. It also gives employees an additional incentive to work hard, knowing that if the firm does well, they will profit. But from an employee's point of view, owning stock in the company for which she or he works can be risky. The employee's wages or salary is already tied to how well the firm performs. If the firm has trouble, the employee could be laid off or have her or his salary reduced. If the employee owns stock in the firm, then there is a double danger - the employee is unemployed or gets a lower salary and the value of the stock falls as well. So owning stock in your own company is a very risky proposition. Most employees would be better off diversifying - owning stock or bonds in other companies

Suppose the government were to replace the income tax with a consumption tax so that interest on savings was not taxed. The result would be that the interest rate a. and investment both would increase. b. and investment both would decrease. c. would increase and investment would decrease. d. would decrease and investment would increase.

D

Suppose the market for loanable funds is in equilibrium. What would happen in the market for loanable funds, other things the same, if the Congress and President increased the maximum contribution limits to 401(k) and 403(b) tax- deferred retirement accounts? a. the interest rate and quantity of loanable funds would increase b. the interest rate and quantity of loanable funds would decrease. c. the interest rate would increase and the quantity of loanable funds would decrease. d. the interest rate would decrease and the quantity of loanable funds would increase.

D

The global economy is a closed economy (since we do not trade with Martians, yet). In recent years the rise of China and other countries in Asia with high savings rates has dramatically increased global saving. Meanwhile the economic downturn has slowed business desire to investment in plant and equipment. In addition, across the globe government's have reduced government budget deficits (often called a fiscal consolidation). Finally, global inflation has fallen in recent years. Together these events imply that in recent years: a. real interest rates are falling, nominal interest rates are rising, and the level of global investment is stable. b. real interest rates and nominal interest rates are rising, and the level of global investment is falling. c. real interest rates and nominal interest rates are falling, and the level of global investment is stable. d. real interest rates and nominal interest rates are falling, and the level of global investment is uncertain.

D

Suppose Sean would like to invest $3,000 of his savings. One way of investing is to purchase stock or bonds from a private company. -Suppose RoboTroid, a robotics firm, is selling stocks to raise money for a new lab—a practice known as equity finance. -Buying a share of RoboTroid stock would give Sean a claim to partial ownership in the firm. -In the event that RoboTroid runs into financial difficulty,the bondholders Correct will be paid first.

Debt finance is the sale of bonds to raise funds. Equity finance is the sale of stock. -When a firm encounters financial difficulty, the firm is obligated to pay off bondholders before giving anything to stockholders. Stockholders, however, stand to gain more if a firm is profitable.

Scenario 2: An investment tax credit effectively lowers the tax bill of any firm that purchases new capital in the relevant time period. Suppose the government repeals a previously existing investment tax credit.

The repeal of the previously existing tax causes the interest rate to fall and the level of investment to fall. The repeal of the previously existing investment tax credit will discourage firms from investing at every interest rate. The policy causes the demand for loanable funds to shift to the left. There is a surplus of loanable funds at the initial interest rate. As lenders lower their interest rates to attract borrowers, the quantity of loanable funds supplied decreases. The equilibrium interest rate falls, and the equilibrium quantity of loanable funds saved and invested falls.

Saving is the source of the supply of loanable funds. As the interest rate falls, the quantity of loanable funds supplied decreases

The supply of loanable funds comes from people who want to save and lend out some of their income. Savers sometimes lend directly by purchasing bonds in financial markets, or they lend indirectly by depositing funds with financial intermediaries, such as banks, that use the deposits to make loans. The interest rate indicates the return that lenders receive on their saving. The supply of loanable funds curve slopes upward. As the interest rate rises, the return on saving increases, and the quantity of loanable funds supplied increases. As the interest rate falls, saving becomes less attractive and consumption becomes more attractive, so the quantity of loanable funds supplied decreases.

Alternatively, Sean could invest by purchasing bonds issued by the U.S. government. Assuming that everything else is equal, a municipal bond issued by a state most likely pays a lower interest rate than a corporate bond issued by an electronics manufacturer.

The tax treatment of the interest earned on a bond influences the bond's interest rate. The federal government does not tax the interest payments from municipal bonds issued by state and local governments in the United States. The interest on federal government bonds or corporate bonds is taxed. The preferential tax treatment on municipal bonds means that they typically pay lower interest rates compared to federal government or corporate bonds.

Individual Retirement Accounts (IRAs) allow people to shelter some of their income from taxation. Suppose the maximum annual contribution to such accounts is $5,000 per person. Now suppose there is a decrease in the maximum contribution, from $5,000 to $3,000 per year.

This change in the tax treatment of interest income from saving causes the equilibrium interest rate in the market for loanable funds to rise and the level of investment spending to decrease . Saving is the source of the supply of loanable funds. Reducing the level of saving that households can shelter from income tax will discourage saving at each interest rate, causing the supply of loanable funds to shift to the left. There is a shortage of loanable funds at the initial interest rate. With more willing borrowers than lenders, the lenders will be able to raise the interest rate they charge for loans. As the interest rate rises, the quantity of loanable funds demanded decreases. The equilibrium interest rate rises, and the equilibrium quantity of loanable funds saved and invested falls.

Explain the difference between saving and investment as defined by a macroeconomist. Which of the following situations represent investment and which represent 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.

To a macroeconomist, saving occurs when a person's income exceeds his consumption, while investment occurs when a person or firm purchases new capital, such as a house or business equipment. a. When your family takes out a mortgage and buys a new house, that is investment because it is a purchase of new capital. b. When you use your $200 paycheck to buy stock in AT&T, that is saving because your income of $200 is not being spent on consumption goods. c. When your roommate earns $100 and deposits it in his account at a bank, that is saving because the money is not spent on consumption goods. d. When you borrow $1,000 from a bank to buy a car to use in your pizza-delivery business, that is investment because the car is a capital good.

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. 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)?

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 as a result 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. e. If households believe that greater government borrowing today implies higher taxes to pay off 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.

Three students have each saved $1,000. Each has an investment opportunity in which he/she can invest up to $2,000. Rates of return on students' investment projects: Harry (5%), Ron (8%), Hermione (20%) a. 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? 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?

a. Harry will have $1,000(1 + 0.05) = $1,050. Ron will have $1,000(1 + 0.08) = $1,080. Hermione will have $1,000(1 + 0.20) = $1,200. The total they have is $3,330. b. Each student would compare the expected rate of return on his or her own project with the market rate of interest (r). 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. c. If r = 7%, Harry would want to lend while Ron and Hermione would want to borrow. The quantity of funds demanded would be $2,000, while the quantity supplied would be $1,000. Since the quantity demanded of loanable funds does not equal the quantity supplied of loanable funds, then 7% cannot be the equilibrium interest rate. If r = 10%, only Hermione would want to borrow. The quantity of funds demanded would be $1,000, while the quantity supplied would be $2,000. Since the quantity demanded of loanable funds does not equal the quantity supplied of loanable funds, then 10% cannot be the equilibrium interest rate. 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 use his own savings for his project, but would want to neither borrow nor lend. Thus quantity demanded = quantity supplied = $1,000. e. Harry will have $1,000(1 + 0.08) = $1,080; so Harry is better off than in part a. Ron will have $1,000(1 + 0.08) = $1,080; so Ron is no worse off than in part a. Hermione will have $2,000(1 + 0.20) - $1,000(1 + 0.08) = $2,400 - $1,080 = $1,320; so Hermione is better off than in part a. Both borrowers and lenders are better off. Note that no one is worse off. As we have seen many times, trade, in the case the trade of loanable funds makes everyone better off. The total they have is $3,480.