ECON 2006 CH10

In January 2008, Tim's Gyms, Inc. owned machines valued at $1 million. During the year, the market value of the equipment fell by 30 percent. During 2008, Tim spent $200,000 on new machines. During 2008, what did Tim's gross investment total?

$200,000

If national saving (S) is $100,00, net taxes (T) is $100,000, and government expenditure (G) is $25,000, how much are households and businesses saving?

$25,000

In an open economy suppose that GDP is $20 trillion. Consumption is $12 trillion, and government spending is $3 trillion. Taxes are $1 trillion. Exports are $1 trillion and imports are $4 trillion. How much is the net capital inflow?

$3 trillion; Net capital inflow is imports minus exports (4 - 1 = $3 trillion)

In an open economy suppose that GDP is $20 trillion. Consumption is $12 trillion, and government spending is $3 trillion. Taxes are $1 trillion. Exports are $1 trillion and imports are $4 trillion. How much is national saving?

$5 trillion; National saving is private saving plus the budget balance (7 + -2 = $5 trillion)

In an open economy suppose that GDP is $20 trillion. Consumption is $12 trillion, and government spending is $3 trillion. Taxes are $1 trillion. Exports are $1 trillion and imports are $4 trillion. How much is private saving?

$7 trillion; Private saving is income (GDP) minus consumption and taxes (20 - 12 - 1 = $7 trillion)

In an open economy suppose that GDP is $20 trillion. Consumption is $12 trillion, and government spending is $3 trillion. Taxes are $1 trillion. Exports are $1 trillion and imports are $4 trillion. How much is investment?

$8 trillion; Investment = saving, which is national saving plus capital inflow (5 + 3 = $8 trillion)

In an open economy suppose that GDP is $20 trillion. Consumption is $12 trillion, and government spending is $3 trillion. Taxes are $1 trillion. Exports are $1 trillion and imports are $4 trillion. How much is the budget balance?

-$2 trillion; The budget balance is taxes minus government spending (1 - 3 = -$2 trillion)

What happened during the Depression, between the 1929 and 1933, and its ripple effects?

-11,000 banks (almost half of all U.S. banks) failed -Ripple effects: Businesses could not get working capital and many people lost their life savings, resulting in lower spending

What are the factors that have driven major changes in interest rates?

-Changes in government policy -Technological innovations that created new investment opportunities -People's expectations about future inflation

What are some examples of financial intermediaries?

-Mutual funds -Pension funds and life insurance companies -Banks

What causes asset price fluctuations?

-The demand for stocks -The demand for other assets -Asset price expectations

What factors can cause the demand curve for loanable funds to shift?

1. Changes in perceived business opportunity 2. Changes in government borrowing

What factors can cause the supply curve of loanable funds to shift?

1. Changes in private savings behavior 2. Changes in net capital inflows

What are the three tasks of a financial system?

1. Reducing transaction costs 2. Reducing risk 3. Providing liquidity

Which of the following assets has the highest liquidity? 1. A bank deposit with a guaranteed interest rate 2. A share of highly diversified mutual fund, which can be quickly sold 3. A share of the family business, which can be sold only if you find a buyer and all other family members agree to the sale

A bank deposit with a guaranteed interest rate; The level of liquidity is highest for a bank deposit since withdrawals can usually be make immediately

Which of the following assets has the lowest risk? 1. A bank deposit with a guaranteed interest rate 2. A share of highly diversified mutual fund, which can be quickly sold 3. A share of the family business, which can be sold only if you find a buyer and all other family members agree to the sale

A bank deposit with a guaranteed interest rate; The level of risk is lowest for a bank deposit since these deposits are insured by the FDIC up to $250,000

What is a life insurance company?

A company that sells policies that guarantee a payment to a policyholder's beneficiaries when the policyholder dies

What does in increase in the supply of loanable funds lead to?

A fall in the equilibrium interest rate

What is a bank deposit?

A financial asset (a claim on the bank's cash) owned by the depositor--and a liability on the bank that holds it

Define bank.

A financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investment spending needs of borrowers who don't want to use the stock or bond markets

What is the loanable funds market?

A hypothetical market that illustrates the market outcome of the demand for funds generated by borrows and the supply of funds provided by lenders

If households believe they will experience higher income in the near future, what is the result?

A leftward shift in the supply of loanable funds cruve

Define liquidity.

A measure of how quickly an asset can be converted into cash with relatively little loss of value. If it can be converted quickly, it's liquid; if not, illiquid

Define financial asset.

A paper claim that entitles the buyer to future income from the seller

Define liability.

A requirement to pay income in the future

What does an increase in the demand for loanable funds lead to?

A rise in the equilibrium interest rate

Define stock.

A share in the ownership of a company

Which of the following assets has the highest transaction costs? 1. A bank deposit with a guaranteed interest rate 2. A share of highly diversified mutual fund, which can be quickly sold 3. A share of the family business, which can be sold only if you find a buyer and all other family members agree to the sale

A share of the family business, which can be sold only if you find a buyer and all other family members agree to the sale; Transaction costs are highest for a share of a family business, since finding a buyer for the share consumers time and resources

What are examples of investment?

A student attends college, a firm builds a new plant, AND the government builds a dam to have a source of hydroelectric power

In the figure, an 8 percent real interest rate results in what?

A surplus of loanable funds

In the figure, if the real interest rate was 8, there would be a what?

A surplus of loanable funds

Define physical asset.

A tangible object that can be used to generate future income

Define pension fund.

A type of mutual fund that holds assets to provide retirement income to its members

Why is a well-functioning financial system a critical ingredient in achieving long-run growth?

Because it encourages greater savings and investment spending, and also ensures that savings and investment spending are undertaken efficiently

Why do firms borrow more when the interest rate falls?

Because more projects will earn enough to pay for themselves

Why do loan contracts specify a nominal interest rate?

Because neither lenders nor borrowers know what inflation will be

Define loss aversion.

Being unwilling to sell an unprofitable asset and accept the loss

What are some types of financial assets?

Bonds, loan-backed securities, and stock

A country that spends more on imports than it earns fro exports must do what?

Borrow the difference from foreigners

Define herd mentality.

Buying an asset when its price has already been driven high and selling it when its price has already been driven low

Diversification _____ the risks of investing in the stock market.

Can reduce but not eliminate

Define physical capital.

Consists of manufactured resources, such as buildings and machines

What is a side effect of government borrowing?

Crowding out

Define crowding out.

Crowding out occurs when a government budget deficit drives up the interest rate and leads to reduced investment spending

The equilibrium real interest rate is determined by the what?

Demand for loanable funds curve and the supply of loanable funds curve

Deposit insurance indirectly helped to create the savings and loan crisis in the United States because of what?

Depositors were not concerned with the types of investments made because they were insured, while at the same time savings and loans were aggressively investing in risky projects

Define budget deficit.

Excess of government spending over over tax revenue

Define budget surplus.

Excess of tax revenue over government spending

True of False: As disposable income increases, the real interest rate increases.

False

True of False: As saving increases, investment by households decreases.

False

True or False: An individual investing all of her savings in a single, new firm is an example of risk diversification.

False

True or False: An individual purchasing only IBM stock is an example of risk diversification.

False

True or False: An insurance company writing earthquake insurance only for the Los Angeles area is an example of risk diversification.

False

True or False: As saving decreases, disposable income increases.

False

True or False: Deposit insurance guarantees savings up to $1,000,000.

False

True or False: Investing in real estate in various states across the U.S. does not diversify risk.

False

True or False: Purchasing the stick of a variety of different companies does not diversify risk.

False

True or False: Regarding the effect expected future income has on savings, as expected future income increases, saving increases.

False

True or False: Regarding the effect expected future income has on savings, middle aged people, earning higher incomes, are not very big savers.

False

True or False: Savings and loan institutions were very profitable during the 1970s when there was high inflation.

False

True or False: Shares of Ford traded on the NYSE are considered physical capital.

False

True or False: The demand for loanable funds is negatively related to the real interest rate because consumers are willing to spend less and hence save more at higher real interest rates.

False

True or False: The demand for loanable funds is negatively related to the real interest rate because interest rate flexibility in financial markets assures an equilibrium in which savings equals investment.

False

True or False: The salaries paid to Ford executives are considered physical capital.

False

True or False: The savings and loan crisis of the 1990s was due to the big U.S. budget deficit.

False

True or False: Writing earthquake insurance policies for the entire Western United States does not diversify risk.

False

True or False: Savings and investment spending may not be equal in the economy as a whole because when the interest rate rises, households will want to save more money and business want to invest.

False; If the quantity of loanable funds supplied (savings) is greater than the demand for loanable funds (investment), then the loanable funds market is not in equilibrium and interest rates will fall until the quantity of loanable funds supplied equals the quantity of loanable funds demanded

The funds used to buy and operate physical capital are what?

Financial capital

Define mutual fund.

Financial intermediary that builds a stock portfolio and resells shares of this portfolio to individual investors

How are savers and borrowers brought together?

Financial markets channel the savings of households to businesses that want to borrow in order to purchase capital equipment

Financial intermediaries are what?

Firms that receive funds from savers and channel them to investors

Define financial capital.

Funds from savings that are available for investment spending

In the figure, the demand for loanable funds curve is drawn for the average expected. If the real interest rate is constant at 6 percent and the expected profit rises, the profit amount of loanable funds demanded will be what?

Greater than $450 billion

Suppose a firm has an investment project which will cost $200,000 and result in $30,000 profit. The firm will not undertake the project if the interest rate is what?

Greater than 15%

When the inflation rate is negative, the real interest rate is what?

Greater than the nominal interest rate

The _____ the expected profit from new capital, the greater the _____.

Greater; investment demand

Net investment equals what?

Gross investment minus depreciation

What is the necessity of finance?

Having a good idea isn't enough to build a business; entrepreneurs need funds--you have to spend money to make money

Define overconfidence.

Having misguided faith that they are able to spot a winning stock

What does behavioral economics (and its subfield in finance) study?

How people make (predictable) mistakes in their decisions

What is the South Korean Miracle?

In 1965, the South Korean government reformed the country's banks and increased interest rates to a level that was attractive to savers. Over the next five years bank deposits increased seven-fold, and businesses launched a great investment spending boom.

Who pays for private investment spending?

In the modern economy, individuals and firms that create physical capital often do it with other people's money

Suppose that expected inflation rises from 3% to 6%. The nominal interest rate will do what?

Increase; The nominal interest rate will rise by 3%--each additional percentage point of inflation drives up the nominal interest rate by 1 percentage point

What is crowding out not a concern in a depressed economy?

Increased government spending raises income and private savings

An increase in the real interest rate increases the quantity of saving because the higher real interest rate does what?

Increases the opportunity cost of current consumption

If a closed economy becomes an open economy, causing an inflow of capital, what effect does this have on the equilibrium interest rate and investment spending?

Interest rate falls, investment rises; The capital inflow increases the supply of loanable funds, which decreases the interest rate and increases investment

Suppose that retired people generally save less than working people at any interest rate and proportion of retired people in the population goes up. What effect does this have on the equilibrium interest rate and investment spending?

Interest rate rises, investment falls; A decrease in saving decreases the supply of loanable funds, which increases interest rates and decreases investment spending

Financial intermediaries reduce risk by doing what?

Investing in a large number of projects with independent returns

Define diversification.

Investing in several assets with unrelated, or independent, risks; reduces risk

What happens when a country sends savings to or receives savings from abroad?

It affects national spending

Due to the recession in 2008, firms decreased their profit expectations. As a result, there was a _____ shift in the _____ loanable funds curve.

Leftward; demand for

If the real interest rate is above the equilibrium real interest rate, what will happen?

Lenders will be unable to find borrowers willing to borrow all of the available funds and the real interest rate will fall

In the figure, the demand for loanable funds curve is drawn for the average expected profit. If the real interest rate is constant at 6 percent and the expected profit falls, the amount of loanable funds will be what?

Less than $450 billion

Why does the supply of loanable funds curve slope upward?

More people are willing to forgo current consumption and make a loan to a borrower when the interest rate is higher

It's hard for people without large amounts of money to build a diversified portfolio. What is the solution?

Mutual funds

A nation's investment must be financed by what?

National saving plus borrowing from the rest of the world

Investment spending = what?

National savings + net capital inflow

Real interest rate = what?

Nominal interes rate - inflation rate

The payoffs resulting from new investment occur when?

Occur in the future but are not known with certainty

When is an investment worth making?

Only if it generates a future return that is greater than the monetary cost of making the investment today

In the figure, the initial supply of loanable funds curve is SLF0 and the initial demand for loanable funds curve is DFL0. An increase in the expected profit would do what?

Only shift the demand for loanable funds curve rightward to a curve such as DLF1

Investors depart from rationality in what systematic ways?

Overconfidence, loss aversion, and herd mentality

What are the three different kinds of capital?

Physical capital, human capital, and financial capital

In the figure, an increase in the expected profit will result in a movement from point E to which point?

Point F

In the figure, a decrease in the real interest rate will result in a movement from point E to which point?

Point G

In the figure, a decrease in the expected profit will result in a movement from point E to which point?

Point H

Financial intermediaries reduce the costs of negotiation by doing what?

Pooling funds

A country with an extra flow of funds from abroad that can used for investment spending has what kind of net capital inflow?

Positive net capital inflow

Where is U.S. investment financed from?

Private saving, government budget surpluses, and borrowing from the rest of the world

Financial intermediaries are institutions that facilitate the movement of funds from savers to investors because they do what?

Provide liquidity

In the market for loanable funds, as the interest rate rises the _____ and the _____.

Quantity of loanable funds supplied increases; quantity of loanable funds demanded decreases

Financial intermediaries do what?

Reduce the costs associated with investment

Suppose that expected inflation rises from 3% to 6%, The real interest rate will do what?

Remain the same; According to the Fisher effect, an increase in expected inflation increases the nominal interest rate, leaving the real interest rate unchanged

Supposed that expected inflation rises from 3% to 6%. The equilibrium quantity of loanable funds will do what?

Remain the same; As long as inflation is expected, it does not affect the equilibrium quantity of loanable funds--both the supply and demand curves for loanable funds are pushed upward, leaving the equilibrium quantity of loanable funds unchanged

Technological progress that increases the expected profit shifts the demand for loanable funds curve which direction and does what to the real interest rate?

Rightward and increases the real interest rate

If households expect an increase in their future incomes, they will save what and consume what today?

Save less and consume more today

If the real interest rate rises, people will do what?

Save more

The amount of _____ by households will be less _____.

Saving; the lower is the real interest rate

What is savings-investing spending identity?

Savings and investing spending are always equal for the economy as a whole

In the figure, new expectations of booking business conditions and a higher expected profit will do what?

Shift the demand for loanable funds curve rightward

In the figure, technological progress that increases the expected profit will do what?

Shift the demand for loanable funds curve rightward

In the figure, the initial supply of loanable funds curve is SFL0 and the initial demand for loanable funds curve is DFL0. An economic expansion that raises disposable income and the expected profit would do what?

Shift the supply of loanable funds curve rightward to a curve such as SLF1, and shift the demand for loanable funds curve rightward to a curve such as DFL1.

A decrease in disposable income does what?

Shifts the supply of loanable funds curve leftward

In the market for loanable funds, an increase in wealth shifts the _____ loanable funds curve _____.

Supply of; leftward

Define present value.

The amount of money needed today to receive a given amount of money at a future date given the interest rate

Define budget balance.

The difference between tax revenue and government spending

What are transaction costs?

The expenses of negotiating and executing a deal

Define human capital.

The improvement in the labor force generated by education and knowledge

What is NOT a determinant of household saving?

The nominal interest rate (thus, the household's wealth, expected future income, and disposable income ARE determinants of household saving)

Suppose that you took out a $1,000 loan in January and had to pay $75 in annual interest. During the year, inflation was 6 percent. What is true regarding the nominal interest rate and the real interest rate?

The nominal interest rate is 7.5 percent and the real interest rate is 1.5 percent

People know that the inflation rate will increase from 3 percent to 5 percent. What is the result?

The nominal interest rate rises by 2 percentage points

The term capital, as used in macroeconomics, refers to what?

The plant, equipment, buildings, and inventories of raw materials and semi-finished goods

Regarding bonds, what is a concern for investors?

The possibility of default (failure of a borrower to make payments as specified)

Regarding the demand for loanable funds, what is the interest rate?

The price of borrowing funds

Gross investment is what?

The purchase of new capital

What is the true cost of borrowing (and payoff to lending)?

The real interest rate

What influences household savings?

The real interest rate, disposable income, and expected future income

Assume that a company announces that although it had a high profit this year, profit will be less than had been previously announced. What effect will this likely have on the stock price of the company?

The stock price will decrease; The expectations of investors about high profits were already built into the stock price. Since profits will be lower than expected, the market's expectations about the company's future stock price will be revised downward, and the stock price will decrease

Assume that other companies in the same industry as XYZ Corporation announce that sales are unexpectedly slow this year. What effect will this likely have on the stock price of XYZ Corporation?

The stock price will decrease; When other companies in the same industry announce slower sales, investors are likely to conclude that sales will also be unexpectedly slow for this company. Investors will revise downward their expectations of future profits and of the future stock price, so the price today will decrease

Approximately, the real interest rate _____ the inflation rate _____ the nominal interest rate.

plus; equals

Assume that a company announces that while profit is low this year, it has discovered a new line of business that will generate a high profit next year. What effect will this likely have on the stock price of the company?

The stock price will increase; Today's stock prices reflect the market's expectation of future stock prices, and according to the efficient market hypothesis, stock prices always take account of all available information. The fact that this year's profits are low is not new information, so it si already built into the share price. However, when it becomes known that the company's profits will be high next year, the price of a share of its stock will rise today, reflecting this new information

Define national savings.

The sum of private savings and the budget balance (the total amount of savings generated within the economy)

In the figure, the economy is at point a on the initial supply of loanable funds curve SLF0. What happens if disposable income decreases?

The supply of loanable funds curve would shift leftward to a curve such as SLF1

In the figure, the economy is at point a on the initial supply of loanable funds curve SLF0. What happens if real wealth decreases?

The supply of loanable funds curve would shift rightward to a curve such as SFL2

Define net capital inflow.

The total flow of funds into a country minus the total flow of funds out of a country

Define wealth.

The value of a household's accumulated savings

When the actual real interest rate is less than the equilibrium real interest rate, what happens?

There are not enough loanable funds supplied for the quantity of loanable funds demanded AND borrows find it difficult to borrow

In the figure, the economy is at point a on the initial demand for loanable funds on curve DLF0. What happens if the real interest rate rises?

There is a movement to a point such as b on the demand for loanable funds curve DLF0

Suppose the current real interest rate is 4 percent and the equilibrium real interest is 3 percent. What does this mean?

There is a surplus of loanable funds

If the real interest rate increases from 3 percent to 5 percent, what will happen?

There will be a movement up along the demand for loanable funds curve

In the figure, the economy is at point a on the initial supply of loanable funds curve SLF0. What happens if the real interest rate rises?

There would be a movement to a point such as b on supply of loanable funds curve SLF0

True or False: A healthy financial system is essential; when it fails it causes instability.

True

True or False: A lumber mill purchasing trees from various forests across the western United States is an example of risk diversification.

True

True or False: Anything that shifts either the supply of loanable funds curve or the demand of loanable funds curve changes the interest rate.

True

True or False: As disposable income decreases, saving decreases.

True

True or False: Deposit insurance was created to prevent bank runs form occurring.

True

True or False: More risky bonds carry higher interest rates.

True

True or False: On any given day, the people with money to lend are not usually the same as people who want to borrow.

True

True or False: Policymakers didn't worry about the massive rise in home values until it began to cause economic slowdown.

True

True or False: Regarding the effect expected future income has on saving, young people typically save very little.

True

True or False: Systematic problems usually lead to large-scale economic crises.

True

True or False: The demand for loanable funds is negatively related to the real interest rate because a lower real interest rate makes more investment projects profitable and hence undertaken.

True

True or False: The production line at the Saturn plant in Tennessee is considered physical capital.

True

True or False: The windshields at the Saturn plant in Tennessee are consider physical capital.

True

True or False: With so many loans packaged together, as in loan-backed securities, it can be difficult to asses the true quality of the asset, as in the financial crisis of 2008.

True

True or False: Writing hurricane insurance policies only in Florida does not diversify risk.

True

True or False: A country's level of economic development is positively related to the level of development of its financial system.

True; Economic development and growth are the result of, among other factors, investment in physical capital. Since savings is the source of funds for investment, the greater the amount saved, the higher investment spending and growth will be. The existence of institutions that facilitate savings will help a country's growth and economic development

True or False: Although many investors may be irrational, it is unlikely that over time they will behave irrationally in exactly the same way--such as always buying sticks the day after the Dow has risen by 1%.

True; The efficient markets hypothesis states that all available information is immediately taken into account in stock prices. If investors consistently bought stocks the day after the Dow rose by 1%, a smart investor would sell on that day because demand--and so stock prices--would be high on that day. If profit can be made that way, eventually many investors would be selling, and it would no longer be true that investors always bought stocks the day after the Dow rose by 1%

Define financial risk.

Uncertainty about future outcomes that involve financial losses or gains

Supposed Molly has an income of $35,000 annually and has inherited a savings account of $20,000. Wyatt has a job that pays $35,000 annually, but has debts totally $6,000. What can we expect?

We can expect Wyatt to save more than Molly this year

What happens when intermediation fails?

When large banks fail, they can take down the economy

If you lend a dollar for a year and at the end of the year the price level has risen by 10 percent, what must have happened?

You must have earned a nominal interest rate of 10 percent to maintain the purchasing power of your loan

Define bond.

An IOU issued by the borrower, usually with a set interest rate and maturity date

What does the Fisher Effect state?

An increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged

Define financial intermediary.

An institute that transforms the funds it gathers from many individuals into financial assets

What does the Efficient Markets Hypothesis state?

Asset prices embody all publicly available information

Define loan-backed securities.

Assets created by pooling individual loans and selling shares in that pool (a process called securitization)

What are the implications of stock markets?

At any time stock prices are fairly valued: They reflect all available information about fundamentals. The prices of stocks and other assets should change only in response to new information about the underlying fundamentals--and should move in a random walk (a "random walk" is the movement over time of an unpredicted variable)