Macro Econ Chapter 29 HW

Which of the following best defines a financial intermediary?

A financial institution that transforms investor funds into financial assets

Brian has grown tired of paying rent each month to his landlord and has decided to purchase a condo. Brian has been saving money and has $33.00 that he will use as a down payment on this condo. He will take out a mortgage to pay the remaining price. Brian finds a suitable condo and negotiates a price of $439.00. Assume that there are no extra fees associated with purchasing the condo. Upon moving in, how much equity does Brian have in this condo? What is Brian's leverage ratio associated with this condo when he moves in?

$33.00 439.00 - 33.00 = 406.00 406.00 / 33.00 = 12.30

Suppose the Chief Financial Officer (CFO) of a company is interested in raising funds for a major investment by issuing bonds of varying maturity to investors. One of the longer-term bonds being issued can be purchased for $25,000.00 per bond and pays $1,900.00 annually to the investor. What is the anual interest rate on this bond?

1,900 / 25,000 = 0.076 0.076 * 100 = 7.6%

Please use the graph to answer the questions. Given the market conditions, what will the prevailing interest rate be? Given the market conditions, how much will be available in loanable funds?

10% $50 billion Explanation: The market for loanable funds operates much as a normal supply and demand model, with the interest rate (the price of borrowing) on the vertical axis and quantity of loanable funds on the horizontal axis. To determine the market interest rate and quantity of available loanable funds, you must find the equilibrium point where the market supply and demand curves intersect. Using the information presented in the graph, you can see that the prevailing market interest rate is 10% and that $50 billion in loans are made.

John has to decide whether to buy a zero-coupon bond with very little risk that costs $950 and will pay $1075 in one year or put his money in a savings account with an annual interest rate of 12%. Compute the difference in the rate of return of the two investments. Round your answer to one decimal place. Which of the two investments will John prefer?

1075 / 950 = 1.1316 1.1316 - 1 = 0.1316 0.1316 * 100 = 13.16 13.16 - 12 = 1.16 1.2% Zero coupon bond Explanation: To decide how to invest his money, John must compute the rates of return of the two investments and compare them. The implied rate of return of the zero-coupon bond equals the difference between what the bond will pay in 11 year (FV) and its price (P) divided by its price (P) and multiplied by 100 rate of return of the zero-coupon bond= (FV−P)/P * 100= (1075−950)/950× 100= 13.2% The rate of return of the savings account is equal to the interest rate, 12%. The difference in the rate of return of the two investments is difference = 13.2%−12%=1.2% Since the difference between the rate of return of the zero-coupon bond and the rate of return of the savings account is positive, John will buy the zero-coupon bond.

A bond that has a face value of $300 maturing in one year is available for purchase for $252. What is the interest rate offered on the bond? Round your answer to the nearest whole percent. If the price of the bond were to increase, how would the interest rate be affected?

19% It would decrease. Explanation: The interest rate on the bond is the rate of return an investor would receive from purchasing it and holding it until maturity. Since there are no coupon payments and the maturity date is in one year, one can simply calculate the percentage change between the bond's initial price and its face value. interest rate=(face value−initial price)/initial price × 100% =(300−252)/252 × 100% ≈19% An increase in the price of the bond would cause the numerator to be smaller in the equation, lowering the interest rate.

What is crowding out? ______ are a mechanism by which crowding out occurs.

A reduction in consumption and investment spending that results from government borrowing Increases in interest rates Explanation: When the government borrows money, there is an increase in the demand for loanable funds. This causes interest rates to rise. As interest rates rise, people save more and consume less; thus, consumption spending falls. Higher interest rates also lead to a decrease in investment spending. Therefore, government borrowing can cause both consumption and investment spending to decline. This is called crowding out.

Banks are known to act as financial intermediaries. Between whom do banks serve this function?

Banks act as financial intermediaries, so called middlemen, between savers and borrowers. Savers place their money in banks and receive interest payments from their savings. Borrowers then approach banks with their needs and receive loans, which they pay back with interest. Banks then make a profit from this interest. As a result, banks indirectly connect borrowers and savers in ways that may not have been possible on their own.

There were many causes that contributed to the financial crisis of 2007-2008. Which of the choices most accurately describes the role of securitization in contributing to the crisis?

Banks bundled mortgages together and then sold them on the market as a financial asset. However, the risk level of these securitized assets was often much higher than the purchaser thought.

Select the definition of consumption smoothing. Identify an example of consumption smoothing.

Borrowing in periods of low income and saving in periods of high income to make consumption less variable than income All of these are examples of consumption smoothing Explanation: Many people follow a pattern of earning relatively little when they are younger and relatively more as they get older. Consumption smoothing refers to borrowing in periods of low income and saving in periods of high income, making consumption less variable than income. This minimizes differences that people experience in standards of living throughout the course of their lives. People exhibit consumption smoothing in many ways. A mortgage allows a person to enjoy the benefit from a very expensive item even if the person's current income level does not allow for purchasing a house outright. Student loans allow students to raise their level of consumption, at least a little bit, so that obtaining a higher education does not require living in poverty. Saving for retirement during middle age is also an example of consumption smoothing, where people save both to repay accrued debt and save for retirement, when income again will fall.

The graph shows the market for loanable funds. Show the effect of an increase in government borrowing by shifting the proper curve. What is the effect of this change on the interest rate? What is the effect of this change on consumption spending? What is the effect of this change on private investment spending?

Demand curve shifts to the right Supply curve stays where it was It rises It falls It falls

Classify each of the given events according to the category that best describes how it affects the equilibrium interest rate in the market for loanable funds.

Increases the interest rate - An investment tax credit - An increase in large investments Decreases the interest rate - An increase in savings - A decrease in investor optimism Explanation: Changes in investments affect the demand to borrow. In particular, an increase of large investments shifts the demand to borrow curve to the right. As a result, the equilibrium interest rate will be higher. An investment tax credit will also shift the demand curve to the right and increase the equilibrium interest rate. A decrease in investor optimism will decrease the demand to borrow. This will shift the demand curve to the left and decrease the equilibrium interest rate. An increase in savings affects the supply of savings by shifting the supply of savings to the right. As a result, the equilibrium interest rate will decrease.

Which of the situations is an example of the crowding-out effect on investment as it pertains to macroeconomics?

Jack wants to borrow money to create a cowboy-themed inflatable bounce house for kids called "Wild Wild West." However, the government is running a deficit which has increased interest rates so much that Jack can no longer afford to borrow the money.

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. 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% 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. In order to open a new car wash facility expected to return 13%, Julius secures a loan. John will shift his stock investments to corporate bonds when they return at least 10%. They do not, so he stays with stocks

Julius = upper half of demand curve jolien = lower half of demand curve John = upper half of supply curve Osi = lower half of supply curve

Suppose that the government changes the tax code to allow additional amounts of money to be placed in 401k retirement accounts, increasing the extent to which people can delay their tax obligation (effectively, this is a tax cut on retirement savings). Show the effect by shifting the appropriate curve in the market for savings. According to this model, what is the result?

Private investment would increase as the cost of borrowing decreased Shift the supply curve to the right Demand curves stays where it is Explanation: The new law described here will result in an increase in the supply of savings, meaning the supply curve should shift to the right. In this case, the supply curve shows how the amount of money that savers are willing to loan varies with the interest rate. Making more money eligible for the tax benefits associated with 401k retirement accounts will induce higher levels of saving, which leads to a lower real interest rate. The lower cost of savings means that participants can finance private investment at a lower cost, increasing the amount of private investment.

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? As interest rate decreases, what happens to the quantity of loanable funds demanded? Which of the terms acts as the "price" in the market for loanable funds? 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?

Quantity supplied will increase Quantity demanded will increase Interest rate The business will not take out the loan Explanation: The interest rate (specifically the real interest rate) is the factor through which balance is achieved between quantity supplied and quantity demanded in the loanable funds market, and thus it acts as the "price" in this market. Producers of loanable funds (lending institutions) and consumers (borrowers) will adjust their quantities supplied and demanded, respectively, to the prevailing real interest rate in the market. At any given rate, an equilibrium quantity will be established. As with a traditional supply and demand curve, as the interest rate decreases, the quantity of loanable funds demanded increases. At lower interest rates, more individuals will seek out loanable funds. The key consideration for any consumer in the loanable funds market is how likely he or she is to receive a rate of return equal to or greater than the interest rate. As the interest rate drops, the likelihood of earning a rate of return at least as high as the interest rate increases, and more individuals will request funds. If a business is unable to secure a rate of return at least as high as the interest rate, it will not desire financing because the outcome would be an overall loss of money. When the rate of return is at least equal to the interest rate, a company will break even. If it is greater, they will make money from the venture. No business will take out a loan with an interest rate higher than the projected rate of return because this would likely put it farther into debt than before, with no net benefit. Businesses will only borrow when the rate of return is projected to be higher than the interest rate. As the interest rate increases, the quantity supplied of loanable funds increases. Lenders have a higher incentive to supply funds because with a higher interest rate, a greater return on their investment is possible. However, this is no guarantee that lenders will, in fact, earn more, because as the interest rate increases, there is a corresponding decrease in the quantity of loanable funds demanded.

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. China decides to reduce its capital investment in the United States, as it expects low returns due to a weak U.S. economy. 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. 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. As a result of a stock market boom, individuals begin to feel richer and spend more while also saving less.

Shift in supply Shift in demand Shift in demand Shift in supply

Suppose that the government is concerned with the unemployment rate and, as a response, offers a tax credit to any firm that builds a new factory in the United States. Show the effect of this policy on the market for loanable funds by shifting the appropriate curve in the graph.

Shift the demand curve to the right Supply curve stays where it is Explanation: The ultimate effect of this tax credit will be firms building more factories. To build factories, firms will need access to financial capital (or, in other words, loans). Some firms will pay for their new factories by borrowing money on financial markets, as a tax credit for building a factory pays for a portion of the building cost and the interest on the capital. Therefore, the impact of this policy in terms of the market for loanable funds is an increase in demand. The demand curve will correspondingly shift to the right. The supply curve, which measures the behavior of savers, will be unaffected by this new tax credit.

Suppose that the government changes the tax code to allow additional amounts of money to be placed in 401(k) retirement accounts, increasing the extent to which people can delay their tax obligations. Show the effect by shifting the appropriate curve in the market for loanable funds.

Shift the supply curve to the right Demand curve stays where it is

The source of the ______ for loanable funds is saving The source of the ______ for loanable funds is investment The ______ represents the price of a loan.

Supply Demand Interest Rate Explanation: A loanable funds market brings together people looking to lend money, making up the supply of loanable funds, and people looking to borrow money, making up the demand for loanable funds. Necessarily, people or institutions who are willing to lend have more money than they currently spend. In other words, lenders are undertaking saving. Saving is the source of the supply of loanable funds. Firms' investment spending can easily exceed their available cash, and, as a result, firms often pay for investment projects by borrowing money. Investment is a source of demand for loanable funds. Interest rates are determined by supply and demand in markets for loanable funds. Because the interest rate measures what buyers must sacrifice in order to borrow money, an interest rate can be thought of as the price of a loan.

The shadow banking system refers to.......

The unregulated non-bank financial firms engaged in borrowing from investors and lending to households and firms

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? Given the market conditions, what will be the prevailing interest rate? Given the market conditions, how much will be available in loanable funds?

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. 10% $50 billion

In the context of budget deficits, what is crowding out? Which of the following is an example of crowding out?

When government borrowing leads to higher interest rates and corresponding decreases in private investment A firm that chooses not to borrow money to invest in new machinery because government borrowing has contributed to high interest rates

Identify the impact on either the supply or demand of loanable funds following the events listed below. a. If economic conditions deteriorate, prompting households to save a larger portion of their income, then ______ of loanable funds will ______. b. In an effort to balance the budget, the government increases taxes paid by businesses. As a result, the ______ for loanable funds will ______. c. If economic conditions improve, increasing the demand for goods and services, then the _____ for loanable funds will ______. d. Innovations in robotics technology vastly improves productivity within manufacturing firms. As a result, the _____for loanable funds will ______.

a. If economic conditions deteriorate, prompting households to save a larger portion of their income, then supply of loanable funds will increase. b. In an effort to balance the budget, the government increases taxes paid by businesses. As a result, the demand for loanable funds will decrease. c. If economic conditions improve, increasing the demand for goods and services, then the demand for loanable funds will increase. d. Innovations in robotics technology vastly improves productivity within manufacturing firms. As a result, the demand for loanable funds will increase. Solution: Any changes in household saving patterns will shift the supply curve for loanable funds. When households save more due to deteriorating economic conditions, the total supply of saving increases, shifting the loanable funds supply curve to the right. An increase in business taxes will reduce the profitability of new investment projects, so the demand for loanable funds will decrease. An improvement in economic conditions, which increases the demand for goods and services, will cause the demand for loanable funds curve to shift to the right, as businesses find it more profitable to invest in production equipment. Advancements in robotics technology, leading to increased productivity, will increase the demand for loanable funds, as firms will have an incentive to increase their investment in equipment and machinery.

Consistent with the pattern predicted by the lifecycle theory of savings, the corresponding graph shows how income and consumption vary as a hypothetical person ages. Use this graph to answer the questions. At which age listed on the graph does this person begin saving? At what age listed on the graph does this person retire completely? At age 70, this person is.... According to the graph, which is most likely to have occurred at age 45?

saving age: 23 years old retirement age: 70 years old dissaving a pay raise Explanation: When income exceeds consumption, saving occurs. In the graph, age 23 is the first age at which saving takes place. The person characterized by this graph experiences a significant decline in income at age 65. Because their income is still positive at age 65, this decline does not represent complete retirement. Perhaps this person has decided to work part time. At age 70, income is zero. This is when the person retires completely. Age 70 represents dissaving rather than saving because consumption is higher than income. A pay raise is the most likely event to have occurred at age 45 because the line showing income becomes higher at that age, corresponding with an increase in compensation at work.

Use the interactive graph to illustrate the effects of a rise in investor confidence. Next, move point E to the new equilibrium. Select the answer that best describes the new equilibrium. What is true of the new equilibrium?

shift demand curve to the right and the supply curve stays The interest rate and the level of investment increased. Dollars Saved = Dollars Borrowed