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Chapter 26

Saving, Investment, and the Financial System

Educators

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Problem 1

For each of the following pairs, which bond would you expect to pay a higher interest rate? Explain.

a. a bond of the U.S. government or a bond of an Eastern European government

b. a bond that repays the principal in year 2020 or a bond that repays the principal in year 2040

c. a bond from Coca-Cola or a bond from a software company you run in your garage

d. a bond issued by the federal government or a bond issued by New York State

Jesse N.
Numerade Educator

Problem 2

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?

Jesse N.
Numerade Educator

Problem 3

Explain the difference between saving and investment as defined by a macro economist. 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.

Jesse N.
Numerade Educator

Problem 4

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.

Kaylee M.
Numerade Educator

Problem 5

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:
$$I = 3,300 - 100r,$$

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.

Heather D.
Numerade Educator

Problem 6

Suppose that Intel is considering building a new chip making factory.

a. Assuming that Intel needs to borrow money in the bond market, why would an increase in interest
rates affect Intel's decision about whether to build the factory?

b. If Intel has enough of its own funds to finance the new factory without borrowing, would an
increase in interest rates still affect Intel's decision about whether to build the factory? Explain.

Jesse N.
Numerade Educator

Problem 7

Three students have each saved $\$$1,000. Each has an investment opportunity in which he or she can
invest up to $\$$2,000. Here are the rates of return on the students' investment projects:

Harry $\quad$ 5 percent

Ron $\quad$ 8 percent

Hermione $\quad$ 20 percent

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?

Jesse N.
Numerade Educator

Problem 8

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.

c. How does the elasticity of supply of loanable funds affect the size of these changes?

d. How does the elasticity of demand for loanable funds affect the size of these changes?

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)?

Jesse N.
Numerade Educator

Problem 9

This chapter explains that investment can be increased both by reducing taxes on private saving and by reducing the government budget deficit.

a. Why is it difficult to implement both of these policies at the same time?

b. What would you need to know about private saving to judge which of these two policies would be
a more effective way to raise investment?

Jesse N.
Numerade Educator