ECO 111 HW 6
Please use the graph to answer the given questions. Assume the people act rationally. Which of the statements best describes a situation represented by point A? A. Carly decides against purchasing a corporate bond because she has another investment opportunity that returns 15%. B. Jeff agrees to lend money to his brother, who plans to use the funds to open a shoe store. C. Janine predicts that, if she borrows to expand operations, she will earn a rate of profit higher than the interest rate of the loan. So, she decides to take out the loan. D. Wayne projects that if he takes out a loan to open another gym franchise, he will earn a lower return than the interest rate he would have to pay, so he decides against it. Given the market conditions, what will be the prevailing interest rate? A. 10% B. 6% C. 18% D. 2% E. 15% Given the market conditions, how much will be available in loanable funds? A. $90 billion B. $50 billion C. $70 billion D. $10 billion E. $30 billion
Point A represents a situation in which projects that promise a rate of return lower than the prevailing interest rate will not be funded. Since Wayne's expansion of his gym franchise promises a return which is lower than the interest rate he would have to pay, he will not choose to expand. This scenario aligns with point A. Each of the three remaining scenarios also correspond to a quadrant on the graph. Janine decides to take out a loan and expand because she projects a rate of return higher than the interest rate, represented by the demand curve above equilibrium (the upper left). Jeff providing a loan to his brother indicates that the expected return is higher than the interest rate the brother will be paying Jeff. Jeff's situation is represented by the supply curve below equilibrium (the lower left). Recall that for supply/demand graphs, the area below the demand curve and above the supply curve to the left of the equilibrium point is total surplus because exchanges are being made between the buyers and sellers. Lastly, Carly deciding whether or not to purchase a corporate bond is equivalent to her deciding whether or not to provide a loan to the corporation issuing the bond. Her decision not to buy is due to her unwillingness to accept an interest rate below 1515%, and thus she is represented by the supply curve above equilibrium (the upper right). The market for loanable funds operates much as a normal supply and demand model, with the interest rate on the vertical axis (the price of borrowing) and quantity of loanable funds on the horizontal axis. In order to determine the market interest rate and quantity of available loanable funds, you must find the equilibrium point for the market supply and demand curves. Using the information presented in the graph, you can see that the prevailing market interest rate is 10% and there are $50 billion in loans made. D. Wayne projects that if he takes out a loan to open another gym franchise, he will earn a lower return than the interest rate he would have to pay, so he decides against it. A. 10% B. $50 billion
A share of ownership in a company
Stock
If the projected rate of return for a project is less than the interest rate for a loan that is necessary to complete the project, how will the borrowing business act? A. The business will proceed anyway, knowing that the return is only an estimate. B. The business will take out the loan. C. The business will demand more funds to cover the shortfall. D. The business will not take out the loan.
D. The business will not take out the loan.
Which of the following best defines a financial intermediary? A. a claim by a buyer to a future payment by a seller B. a collection of stocks and bonds issued to investors C. an asset sold by a company which entitles the buyer to partial ownership D. a financial institution that transforms investor funds into financial assets
D. a financial institution that transforms investor funds into financial assets
Which of the terms acts as the "price" in the market for loanable funds? A. capital B. interest rate C. supply D. demand
B. interest rate
Funds that are kept in a bank that must be relinquished upon the owner's request
Bank deposit
Indicate whether each of the following statements is true or false. a. An increase in government spending can crowd out private investment. b. An improvement in the budget balance increases the demand for financial capital. c. An increase in private consumption may crowd out private investment. d. Lower interest rates can lead to private investment being crowded out. e. A trade balance in surplus increases the supply of financial capital. f. If private savings is equal to private investment, then there is neither a budget surplus nor a budget deficit.
National savings and investment tell us that the quantity of financial capital supplied equals the quantity of financial capital demanded. The national savings identity can be rewritten as private savings+trade deficit=private investment+government budget deficit private savings+(imports−exports)=private investment+(government spending−taxes) a. True. As government spending increases, it represents an increase in the quantity of financial capital demanded, implying that quantity demanded is not equal to quantity supplied. One way the identity can be brought back to equilibrium is if there is a decrease in private investment. b. False. If the government budget balance improves, the government will be borrowing less, which implies a reduction in the demand for financial capital. c. True. An increase in private consumption implies, ceteris paribus, a reduction in savings. Thus, it reduces the pool of financial capital available, thereby crowding out private investment. d. False. A higher interest rate can crowd out private investment. e. False. Recall that national savings=(domestic) investment+net foreign investment and that net foreign investment is equivalent to net exports or the trade balance. This equivalence implies that an improvement in the trade balance increases net foreign investment and net exports. According to the savings-investment identity, a rise in net foreign investment leads to a rise in national savings. However, since the increase in national savings is due to an increase in foreign investments, the domestic supply of loanable funds is unaffected. f. False. Recall that NX=NFI and SNational=SPrivate+SPublic So when savings is equal to private investment, public savings could be positive, i.e., a budget surplus, negative, i.e., a budget deficit, or zero, i.e., a balanced budget. All that is required is that the trade balance offsets the budget balance.
Which of the four graphs best demonstrates the Fisher effect?
Of the four graphs shown, graph B best demonstrates the Fisher effect. American economist Irving Fisher proposed that the nominal market equilibrium interest rate would increase, depending on expected future inflation, at a ratio of 1% to 1%. Graph B shows a direct shift of both the supply and demand curves upward, showing an increase in the nominal interest rate. The other graphs do not demonstrate the Fisher effect. Graph A shows a simple shift in demand, whereas graph C shows a simple shift in supply. Graph D does show an overall increase in the market interest rate, but with movement to the right as well, which would indicate other factors besides inflation having an effect on the loanable funds market. The Fisher effect relates to consumers' perception of future inflation and how it affects their current borrowing habits. Fisher theorized that consumers would borrow at an interest rate up to the current interest rate plus perceived future inflation, because at the point of repayment, inflation would have made up for the difference between this rate and the current market rate. This information contradicts the statement that consumers ignore inflation and also shows that interest rates are, to some degree at least, predictable. Fisher's theory accepts as fact that the interest rate changes, and seeks to understand how consumers process and respond to such changes.
Determine which type of financial asset is described in each scenario. a. Caleb has developed a prototype garlic-peeling device that he hopes to sell to the public. He is having his startup issue securities that offer buyers the promise to pay a specified amount of interest each year plus the principal in five years. Caleb is b. Audrey wants to buy a new car but does not have enough cash. She gets funding from her local bank with the promise that she will make monthly payments for the next three years to repay the original amount lent to her plus 66% interest. Audrey is c. Lyle and Shane start a business selling pencil sharpeners to elementary schools. Their company becomes an instant success, and they decide to allow people to start buying small shares of their company. This gives individuals who buy shares the right to vote in company decisions and a small percentage of the profits. Lyle and Shane are d. Rand Capital, a financial industry conglomerate, pools together several hundred home mortgages and sells shares in them to groups of investors. However, many investors decide against this option because of the risk involved and the difficulty of assessing the quality of such a large number of individual mortgages. Rand Capital is e. Jack decides to build a chateau in the mountains of Colorado and operate it as a ski resort. He secures funding from a local commercial bank after discussing his business plan with the bank. He promises to pay back the principal plus interest over the next 2020 years. Jack is
Seeking to raise capital, Caleb is selling bonds. As part of the deal, he will repay a set amount of interest each year to the holders of his bonds and pay back the principal amount in five years. He will presumably raise this money from profits he makes with his company. Bonds are similar to loans, but different in that a bond has predetermined terms and, therefore, limits transaction costs. a. selling bonds Audrey takes out a loan to buy her new car. She begins making payments immediately and will continue until the principal and interest are paid off. Jack is also taking out a loan to open his ski resort in Colorado. This is the simplest type of financial asset, as it is an agreement generally between an individual and a lending institution. There are specific terms with each loan. b. taking out a loan Lyle and Shane are selling stock in their company. As companies grow larger and more profitable, they sometimes sell stock to reduce the amount of risk held by any one individual. Each stockholder technically owns a part of the company, equal to the share all of the stock issued that they own. Depending on the type of stock issued, stock can entitle its owner to a voting share in company decisions and a share of company profits. c. selling stock Rand Capital is involved in producing loan-backed securities. These are investment opportunities made up of pooled loans which offer diversity and a chance for a significant return on investment, though they also contain a high amount of risk. The risk involved originates mainly from the difficulty in knowing the stability or many of the loans involved, since generally they are high in number. d. floating a loan-backed security e. taking out a loan
An agreement between a lender and a borrower
Loan
After reading the given descriptions, please place the correct label by the quadrant on the graph that best describes each person's position in the market for loanable funds. 1. Jolien decides not to take out a loan to fund expanding her grocery store because she projects it will only earn a return of 4%. 2. Osi closely follows the market for United States Treasury Bonds. He is willing to invest in them anytime the rate of return is 5% or higher, and sees that this is the case. 3. In order to open a new car wash facility expected to return 13%, Julius secures a loan. 4. John will shift his stock investments to corporate bonds when they return at least 10%. They do not, so he stays with stocks.
1. Jolien decides not to take out a loan because she will only accept a maximum interest rate of 4%, below the market equilibrium interest rate. An interest rate higher than this means she will suffer a loss. 2. Osi will invest in U.S. Treasury Bonds whenever there is a rate of at least 5%. Because the market equilibrium rate is higher than this, he will choose to invest in bonds. 3. Julius is willing to accept a loan up to a rate of 13% interest. Since the market equilibrium rate is at 8%, below Julius's expected return (the maximum interest rate he would be willing to pay), he will accept the loan and borrow the money. 4. John will only invest in bonds when the return is at least 10%. Since the equilibrium interest rate is lower than this, he chooses to invest in stocks (which generally have a higher return at the cost of higher risk).
A promise to pay issued by a borrower with annual interest payments and a principal payment at maturity.
Bond
In a small, closed economy, national income (GDP) is $400.00 million for the current month. Individuals have spent $150.00 million on the consumption of goods and services. They have paid a total of $200.00 million in taxes, and the government has spent $150.00 million on goods and services this month. Use this information and the national income identity to answer the questions. How much is spent on investment in this economy? What is national saving in this economy? How are investment and national saving related in an economy like this? A. National saving is always less than investment. B. Investment is a component of national saving. C. National saving equals investment. D. They are unrelated.
In a closed economy, there is no interaction with other economies and therefore no exports or imports. The net exports term is then zero and not present in a closed economy. National income for a closed economy, as measured with GDP, can be expressed as GDP=C+I+GGDP=C+I+G The equation states that GDP is the sum of private consumption, investment, and government spending. This equation can be referred to as the national income identity. By subtracting private consumption and government spending from both sides, it is possible to solve for investment. I=GDP−C−G In the question, GDP is $400.00 million, private consumption is $150.00 million, and government spending is $150.00 million. Notice, that although important, taxes paid to the government do not enter the national income identity. Investment can be calculated as I=GDP−C−G=$400.00 million−$150.00 million−$150.00 million=$100.00 million investment: $100 million National saving (S) is the total income in the economy that remains after paying for consumption and government spending. S=GDP−C−GS=GDP−C−G S=IS=I This is equal to the solution for national investment. Therefore, in a closed economy like this, national saving must equal investment. Every dollar in the economy that is saved (not used for consumption or government spending) is in turn invested. This is facilitated by financial markets and intermediaries. saving: $100 million C. National saving equals investment.
Please decide whether each of the scenarios related to the loanable funds market will result in a shift in supply or a shift in demand. a. China decides to reduce its capital investment in the United States, as it expects low returns due to a weak U.S. economy. b. Calopolis, a college town in Northern California, has for many years banned the presence of fast food restaurants in city limits. As of 2012, however, the city will allow several fast food companies to open franchised locations. c. Due to an increase in revenues after a tax hike, the United States is able to eliminate the deficit and begins to maintain a balanced budget for the first time in several decades. d. As a result of a stock market boom, individuals begin to feel richer and spend more while also saving less.
a. shift in supply b. shift in demand c. shift in supply d. shift in demand
As interest rate decreases, what happens to the quantity of loanable funds demanded? A. Quantity demanded will increase. B. Some borrowers will demand more funds whereas others will demand less. C. There will be no change in quantity demanded. D. Quantity demanded will decrease.
A. Quantity demanded will increase.
Please answer the given four questions related to the market for loanable funds. What effect will an increase in interest rates have on the quantity of loanable funds supplied? A. Quantity supplied will increase. B. Some lenders will offer more whereas others offer less. C. Quantity supplied will decrease. D. There will be no change in quantity supplied.
A. Quantity supplied will increase.
Collaboration with Congress during the Clinton Administration allowed for an aggressive deficit-cutting plan to pass. As a result, the government was able to reach a balanced budget at the end of the 90's. Move the supply and/or demand curves to describe the expected effect that this deficit-reduction likely had upon the loanable funds market. As a result, private investment should have A. decreased as the cost of borrowing decreased. B. increased because the cost of borrowing decreased. C. decreased as the cost of borrowing increased. D. increased as the cost of borrowing increased.
A government deficit means that tax collections amount to less than government spending during a fiscal year. This means the government is a borrower, or a demander in the loanable funds market. In a sense, government borrowing "crowds out" private investment. Thus, a reduction in deficits means a decrease in demand, where the crowding out effect is reduced. Thus, the demand for loanable funds shifts to the left, allowing private market participants to contract obligations at a lower interest rate. The lower cost of funds means that participants can finance private investment at a lower cost, increasing the amount of private investment. B. increased because the cost of borrowing decreased.
There are two aspects of efficiency that the equilibrium of market for loanable funds exhibits. Select the TWO statements that characterize these two aspects of efficiency. A. Savers who lend money are willing to accept a higher minimum interest rate than potential savers who do not lend money. B. Investment projects that are financed by savers have larger rates of return than projects that do not receive financing. C. There is always a small surplus of funds in the market. D. All potential savers lend money. E. Investment projects that are financed have smaller rates of return than projects not receiving financing. F. Savers who lend money are willing to accept a lower minimum interest rate than potential savers who do not lend money.
B. Investment projects that are financed by savers have larger rates of return than projects that do not receive financing. and F. Savers who lend money are willing to accept a lower minimum interest rate than potential savers who do not lend money.
The accompanying graph represents the market for loanable funds in the hypothetical country of Bunko. Assume the market is initially in equilibrium and inflation expectations are 2%. a. Adjust the graph to demonstrate the effects of inflation expectations increasing from 2% to 4%. b. What is the real interest rate after the change in inflation expectations? A. 7% B. 2% C. 5% D. 3% c. Which effect below characterizes the relationship between inflation expectations and nominal interest rates? A. The Leontief Paradox B. The Fisher effect C. The Pigou effect D. The Inflation effect
We are given that when expected future inflation is 2%, the equilibrium nominal interest rate is 5% and the equilibrium quantity of loanable funds is $10 billion. The nominal interest rate is determined by the equation: Nominal Interest Rate= Real Interest Rate+ InflationNominal Interest Rate= Real Interest Rate+ Inflation Rearranging the equations yields: Real Interest Rate= Nominal Interest Rate− InflationReal Interest Rate= Nominal Interest Rate− Inflation Taking our initial values we get: Real Interest Rate=5%−2%=3% The increase in inflation expectations by 2 percentage points results in a shift to the left (decrease) in the supply of loanable funds because savers now require an additional 2% to maintain their real return of 3%. The demand for loanable funds will shift to the right (increase) reflecting an increased willingness to pay on the borrowers part given the expected increase in the price level. At the new equilibrium the nominal interest rate is 7% and the equilibrium quantity of loanable funds is still $10 billion. Be mindful that the 7% is calculated as: Nominal Interest Rate=3%+4%=7% Where the 4% is the combined effect of the two percentage point increase in demand and two percentage point decrease in supply. The real interest rate is: Real Interest Rate=7%−4%=3% The Fisher effect describes the tendency for nominal interest rates and inflation expectations to move in the same direction.
Adjust the graph to show how an increase of $25.8 billion dollars in the government's budget deficit affects this loanable funds market, holding all else equal. Select the answer that describes the adjustment in the loanable funds market. A. The deficit decreases the demand for loanable funds and shifts the demand curve to the left, decreasing the interest rate and crowding out investment spending. B. The deficit decreases national savings and shifts the supply curve to the left, increasing the interest rate and crowding out investment spending. C. The deficit increases the demand for loanable funds and shifts the demand curve to the right, increasing the interest rate and crowding out investment spending. D. The deficit increases national savings and shifts the supply curve to the right, decreasing the interest rate and crowding out investment spending.
When the government experiences a budget deficit, its spending exceeds tax revenue. The government must borrow funds to pay for the deficit. In the market for loanable funds, borrowers are represented by the demand curve. Therefore, the budget deficit increases government demand for loanable funds, which shifts the demand for loanable funds to the right. As with other markets, an increase in the demand for loanable funds increases the price of loanable funds, the interest rate. As a result, the cost of investment increases, and some private sector investments are not made since the increased cost of borrowing reduces the profitability of such investments. This phenomenon is called crowding out. C. The deficit increases the demand for loanable funds and shifts the demand curve to the right, increasing the interest rate and crowding out investment spending.
Determine whether the statements listed regarding the savings-investment spending identity are true or false. a. The budget balance can be either positive or negative. b. National budget deficits are NOT included in the calculation of national savings. c. The national savings are the combined value of all private savings and the budget balance. d. Outflows of funds can only be generated by countries with a larger gross domestic product (GDP) per capita than the country receiving the funds. Why do funding from national savings and funding obtained from capital inflows differ? Because A. funds from national savings must be repaid, whereas capital inflows do not have to be repaid. B. national saving funds can be used for a wider variety of investments than capital inflows. C. capital inflows come from domestic individuals, whereas national savings come from government sources. D. national savings are repaid domestically, whereas capital inflows are repaid to a foreigner.
a. True. The budget balance is the difference between tax revenue and government spending, so depending on the situation, it can be either positive or negative. If the government spends less than it takes in, the budget balance is positive. If it spends more than it receives, the budget balance is negative. Note that the budget balance is not the same as a balanced budget, a term you may have encountered in studying government budget deficits. b. False. The national savings are the combination of all private savings and the budget balance. In other words, it is considered the measure of all domestically held savings within a country. The national savings will also be affected by the budget deficit or the surplus since these factors determine the value of the budget balance. c. True. Outflows of funds can, in fact, come from any given country. These funds come from domestic savings that finance investment spending in any other country. There is no relationship between a country's GDP per capita and its official ability to invest in another country, though the actual reality of how much it can invest will be affected by GDP. d. False. Lastly, it is false that national budget deficits are not included in the calculation of national savings. Deficits, along with surpluses, determine the value of the budget balance, which is combined with the total value of all private savings to determine the national savings. Deficits inevitably cause a reduction in the national savings. The second question relates to the difference between national savings and capital inflows. In reality, both sources provide the same kind of available funding. What you can purchase with one, you can purchase with the other, and in this way they are indistinguishable. Secondly, capital inflows come from foreign sources, whereas national savings is made up of all savings from domestic sources, both individual and governmental. Lastly, both sources must be repaid, as they are investment spending, generally in physical capital. The major difference between the two sources is that capital inflows must be repaid to foreign sources, whereas national savings must be repaid to domestic sources. This distinction is important because repaying capital inflows involves exchange rate risk since both the capital and interest must be repaid to a foreign source instead of a domestic source, as happens with national savings. D. Because national savings are repaid domestically, whereas capital inflows are repaid to a foreigner.
Please select the correct term for each definition. a. the difference between the amount the government collects and how much it spends b. when the preceding term is combined with all of the privately‑held savings from across the country c. the result when the government spends more money than it takes in through taxes d. the net amount of funds coming into a country e. when the government spends less money than it takes in through taxes
a. budget balance b. national savings c. budget deficit d. capital inflow e. budget surplus