Explain how borrowing and lending decisions are made and how these decisions interact in the loanable funds market.

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1 Finance, Saving, and Investment Chapter CHAPTER CHECKLIST Describe the financial markets and the key financial institutions. Finance is the lending and borrowing that moves funds from savers to spenders. Physical capital is the tools, machines, buildings, and other items that have been produced in the past and are used to produce additional goods and services. Financial capital is the funds firms use to buy and operate physical capital. Gross investment is the total amount spent on new capital goods; net investment equals gross investment minus depreciation. Net investment is the change in the quantity of capital. Saving is the amount of income that is not paid in taxes or spent on consumption. Saving is the source of financial capital. Borrowers and savers interact in the markets for financial capital: the loan markets, the bond markets, and the stock markets. Financial institutions, such as investment banks, commercial banks, government-sponsored mortgage lenders, pension funds, and insurance companies, are firms that operate on both sides of the markets for financial capital. A financial institution s net worth is the market value of what it has lent minus the market value of what it has borrowed. If net worth is negative, the firm is insolvent; if a firm is faced with a sudden demand to repay more of what it has borrowed than the amount of cash it has on hand, the firm is illiquid. There is an inverse relationship between the interest rate and the price of an asset; if the asset price rises, the interest rate falls. Explain how borrowing and lending decisions are made and how these decisions interact in the loanable funds market. The main source of the demand for loanable funds is firms demand for loanable funds to finance investment. Other things remaining the same, the higher the real interest rate, the smaller the quantity of loanable funds demanded so that the demand for loanable funds curve slopes downward. The demand for loanable funds changes when the expected profit changes; if the expected profit increases, the demand for loanable funds increases. The main source of the supply of loanable funds is households supply of savings. Other things remaining the same, the higher the real interest rate, the greater the quantity of loanable funds supplied so that the supply of loanable funds curve slopes upward. Factors that change the supply of loanable funds are: disposable income, wealth, expected future income, and default risk. The loanable funds market equilibrium occurs at the real interest rate at which the quantity of loanable funds demanded equals the quantity supplied. Explain how a government budget surplus or deficit influences the real interest rate, investment, and saving. A government budget surplus adds to the supply of loanable funds, thereby lowering the real interest rate and increasing the quantity of investment. A government budget deficit adds to the demand for loanable funds, raising the real interest rate and decreasing (crowding out) investment. The Ricardo-Barro effect says that private saving increases to offset a government budget deficit so no crowding out occurs.

2 136 Part 3. THE REAL ECONOMY CHECKPOINT 10.1 Describe the financial markets and the key financial institutions. Quick Review Net investment Net investment is the change in the quantity of capital and equals gross investment minus depreciation. Interest rates and asset prices The interest rate on an asset is a percentage of the asset s price. So if the asset s price rises, then the interest rate on the asset falls and if the asset s price falls, then the interest rate on the asset rises. Additional Practice Problems On December 31, 2008 CSX railroad had capital of $19.5 billion dollars. During 2009 CSX made investments of $1.0 billion and had $0.4 billion of capital depreciate. a. What was CSX s gross investment? b. What was CSX s net investment? c. What was the amount of CSX s capital stock on December 31, 2009? By how much did the capital stock change? How does this answer compare to the answer to part (b)? 2. Nvidia, the 3-D graphics accelerator company, wanted to raise $200 million to build a new headquarters building and buy other physical capital. What methods could Nvidia have used to obtain the financial capital to purchase the physical capital it needed? 3. For a financial institution, what is the relationship between net wealth, solvency, and insolvency? Solutions to Additional Practice Problems a. CSX s gross investment is equal to their total investment, $1.0 billion. 1b. CSX s net investment is equal to its gross investment minus its depreciation, or $1.0 billion minus $0.4 billion, which is $0.6 billion. 1c. CSX s capital stock on December 31, 2009 equals its capital stock on December 31, 2008 plus its (gross) investment minus its depreciation, or $19.5 billion + $1.0 billion $0.4 billion, which is $20.1 billion. CSX s capital increased by $0.6 billion, which is the same as CSX s net investment. It is the case that the change in the capital stock equals net investment. 2. Nvidia had a number of choices in the markets for financial capital. It could have sold new shares of stock, so the current stockholders would share future profits with new stockholders. It could have sold bonds, which means it would be borrowing the funds from the buyers of the bonds. Or it could have arranged a bank loan. If Nvidia sold bonds or borrowed from a bank, Nvidia would have increased its debt and would be required at some time to repay whoever loaned it the funds. As it happens, Nvidia actually financed its new capital by selling bonds. 3. A financial institution s net worth is the market value of what it has lent (which are its assets) minus the market value of what it has borrowed (which are its liabilities). If the net worth is positive, the firm is solvent but if the net worth is negative, then the firm is insolvent. Self Test 10.1 Fill in the blanks Finance and money (are; are not) essentially the same thing. (Physical; Financial) capital consists of tools, instruments, machines, buildings, and other items that have been produced in the past and that are used to produce goods and services. Net investment equals (gross investment; depreciation) minus (gross investment; depreciation). A (bond; stock) is a certificate of ownership and claim to the profit that a firm makes. Fannie Mae is an example of (an investment bank, a government-sponsored mortgage lender). If other things remain the same, an increase in the price of an asset (raises; lowers) the interest rate on the asset.

3 Chapter 10. Finance, Saving, and Investment 137 True or false 1. Financial capital and physical capital are two different names for the same thing. 2. Net investment equals gross investment minus depreciation. 3. The loan market is one of the nation s financial capital markets. 4. A bond issued by a firm is a certificate of ownership and claim to the profits that the firm makes. 5. Investment banks and commercial banks are both examples of financial institutions. 6. A firm that is insolvent must also be illiquid. Multiple choice 1. Which of the following is not an example of physical capital? a. a building b. a bond c. a dump truck d. a lawn mower e. a computer 2. The decrease in the value of capital that results from its use and obsolescence is a. appreciation. b. deconstruction. c. depreciation. d. gross investment. e. net investment. 3. Which of the following formulas is correct? a. Net investment = gross investment + depreciation b. Net investment = gross investment + capital c. Net investment = gross investment depreciation d Net investment = gross investment saving e. Net investment = gross investment wealth 4. Intel s capital at the end of the year equals Intel s capital at the beginning of the year a. minus its stock dividends. b. plus net investment. c. minus depreciation. d. plus gross investment. e. plus depreciation. 5. Economists use the term financial markets to mean the markets in which a. firms purchase their physical capital. b. firms supply their goods and services. c. households supply their labor services. d. firms get the funds that they use to buy physical capital. e. the government borrows to fund any budget surplus. 6. When a student uses a credit card to buy an ipod, the student is a. borrowing in the bond market. b. lending in the bond market. c. lending in the loan market. d. borrowing in the loan market. e. lending in the stock market. 7. Which of the following is not a financial institution? a. an insurance company b. a pension fund c. Freddie Mac d. a commercial bank e. None of the above is correct because they are all financial institutions. 8. If the market value of what it has lent is less than the market value of it has borrowed, a financial institution s net worth is and it is. a. negative; illiquid but not necessarily insolvent b. negative; insolvent but not necessarily illiquid c. positive; illiquid and insolvent d. negative; illiquid and insolvent e. positive; insolvent but not necessarily illiquid 9. A bond s price is $80 and the bond pays $8 in interest every year. The bond s interest rate is. a. 8 percent b. 10 percent c. 4 percent d. 80 percent e. None of the above are correct.

4 138 Part 3. THE REAL ECONOMY Short answer and numeric questions 1. What is the relationship between physical capital and financial capital? 2. What is the difference between gross investment and capital? 3. In 2012, Regis Hair purchased 10 hair dryers for $3,300 each. During the year, depreciation was $13,000. What was the amount of Regis gross investment and net investment? 4. What are Fannie Mae and Freddie Mac? How do they operate on both sides of the financial markets? 5. Suppose a bond pays interest of $40 per year and its price is $600. What is the interest rate on the bond? If the price rises to $800, what now is the bond s interest rate? Additional Exercises (also in MyEconLab Test A) 1. Annie runs a fitness center. On December 31, 2011, she bought an existing business with exercise equipment and a building worth $300,000. During 2012, business was poor, so she sold some of her equipment for $100,000. What was Annie s gross investment, depreciation, and net investment during 2012? What was the value of Annie s capital at the end of 2012? 2. Karrie is a golf pro, and after she paid taxes, her income from golf and from stocks and bonds was $1,500,000 in At the beginning of 2012, she owned $900,000 worth of stocks and bonds. At the end of 2012, Karrie s stocks and bonds were worth $1,900,000. How much did Karrie save during 2012 and how much did she spend on consumption goods and services? CHECKPOINT 10.2 Explain how borrowing and lending decisions are made and how these decisions interact in the loanable funds market. Quick Review Demand for loanable funds The relationship between the quantity of loanable funds demanded and the real interest rate, other things remaining the same. Supply of loanable funds The relationship between the quantity of loanable funds supplied and the real interest rate, other things remaining the same. Additional Practice Problems Over the past decade or so, the development of ever more powerful computers has increased the profit from investing in new personal computers. This effect has affected all firms in the economy. The initial demand for loanable funds is shown in the figure. Use the figure to show the effect the higher expected profit has on the demand for loanable funds. 2. In 2013, in the United States at a real interest rate of 4 percent a year, the quantity of loanable funds supplied is $2.0 trillion; at a real interest rate of 6 percent a year, the quantity of loanable funds supplied is $2.5 trillion; and at a real interest rate of 8 percent a year, the quantity of loanable funds supplied is $3.0 trillion. a. In the figure, draw a graph of the U.S. supply of loanable funds curve. b. In 2013 a large number of households start to believe that their future disposable income will be higher than they had previously thought. Explain how this belief influ-

5 Chapter 10. Finance, Saving, and Investment 139 ences the supply of loanable funds. Illustrate the effect of this change on the supply of loanable funds curve. c. In 2014, the housing market recovers so that house prices soar and U.S. households wealth increases. If other things remain the same, explain how this change influences the supply of loanable funds. What is the effect on the supply of loanable funds curve? 3. Draw a graph illustrating the effect on the equilibrium real interest rate and equilibrium saving and investment when the supply of loanable funds increases and the demand for loanable funds increases by more. Solutions to Additional Practice Problems An increase in the expected profit from investing in personal computers increases investment demand and shifts the demand for loanable funds curve rightward. In the figure, the demand for loanable funds curve shifts rightward from DLF0 to DLF1. At any real interest rate firms have increased the quantity of investment they demand. 2a. The figure illustrates the U.S. supply of loanable funds curve. The supply curve, SLF0, slopes upward because an increase in the real interest rate increases saving, which increases the quantity of loanable funds supplied. 2b. An increase in expected future income decreases the amount people s saving and thereby decreases the supply of loanable funds. The U.S. supply of loanable funds decreases and the supply of loanable funds curve shifts leftward. In the above figure, the supply of loanable funds curve shifts leftward from SLF0 to SLF1. At any real interest rate, households have decreased the quantity of loanable funds they supply. 2c. The increase in people s wealth decreases the amount they save at each real interest rate. Saving decreases so the supply of loanable funds decreases and the supply of loanable funds curve shifts leftward. In the above figure, the supply of loanable funds curve shifts leftward from SLF0 to SLF1. 3. The figure that shows the demand for loanable funds curve and the supply of loanable funds curve illustrates how the real interest rate is determined. Use this diagram the same way you use the supply and demand figures you studied in Chapter 4. Equilibrium occurs where the demand for loanable funds curve intersects the supply of loanable funds curve and a shift in either curve changes the equilibrium real interest rate and the equilibrium quantity of loanable funds. In this case, the increase in the supply of loanable funds shifts the supply of loanable funds curve rightward. The increase in the demand for loanable funds shifts the demand for loanable funds curve rightward. The shift of the demand for loanable funds curve exceeds the shift of the supply of loanable funds curve, so, as illustrated in the figure, the real interest rate rises, from 5.5 percent to 6.0 percent, and the quantity of loanable funds increases, from $2 trillion to $3 trillion.

6 140 Part 3. THE REAL ECONOMY Self Test 10.2 Fill in the blanks Other things remaining the same, the higher the real interest rate, the (greater; smaller) the quantity of loanable funds demanded. An increase in expected profit (increases; decreases) the demand for loanable funds. Other things remaining the same, the higher the real interest rate, the (greater; smaller) the quantity of loanable funds supplied. An increase in saving (increases; decreases) loanable funds. The financial market is in equilibrium when the quantity of loanable funds supplied the quantity of loanable funds demanded. True or false 1. Other things remaining the same, the higher the real interest rate, the smaller the quantity of loanable funds demanded. 2. When the expected profit changes, there is a movement along the demand for loanable funds curve. 3. The real interest rate is the opportunity cost of consumption expenditure. 4. An increase in wealth leads to a decrease in saving. 5. If the real interest rate is greater than the equilibrium real interest rate, there is a shortage of loanable funds in the financial market. Multiple choice 1. If the real interest rate falls, other things being the same, the quantity of loanable funds demanded and the quantity of loanable funds supplied. a. increases; decreases b. increases; increases c. decreases; does not change d. does not change; decreases e. decreases; decreases 2. The demand for loanable funds a. increases in a recession. b. decreases in an expansion. c. increases when firms are optimistic about the profit from investing in capital. d. increases when wealth increases. e. decreases when wealth increases. 3. The shift of the demand for loanable funds curve in Figure 10.1 could reflect in investment and might be the result of. a. an increase; an increase in households wealth b. an increase; a decrease in households wealth c. a decrease; a fall in expected profit d. a decrease; a fall in the default risk e. an increase; a rise in expected profit 4. Other things remaining the same, a in the real interest rate the quantity of saving and the quantity of loanable funds supplied. a. fall; increases; increases b. rise; increases; increases c. fall; increases; decreases d. fall; decreases; increases e. rise; increases; decreases

7 Chapter 10. Finance, Saving, and Investment If the real interest rate falls, there is a. an upward movement along the supply of loanable funds curve. b. a downward movement along the supply of loanable funds curve. c. a rightward shift of the supply of loanable funds curve and no shift in the demand for loanable funds curve. d. a leftward shift of the supply of loanable funds curve and no shift in the demand for loanable funds curve. e. a leftward shift of the supply of loanable funds curve and a rightward shift in the demand for loanable funds curve. 6. An increase in wealth leads to loanable funds. a. an increase in the supply of b. an increase in the demand for c. a decrease in the supply of d. a decrease in the demand for e. no change in either the supply of loanable funds or the demand for 7. If, at the current interest rate, the quantity of loanable funds supplied is less than the quantity of loanable funds demanded, then a. the supply of loanable funds curve shifts rightward and the real interest rate rises. b. the supply of loanable funds curve shifts leftward and the real interest rate falls. c. the real interest rate falls. d. the real interest rate rises. e. the supply of loanable funds curve shifts leftward and the real interest rate rises. 8. If expected profit falls, the demand for loanable funds curve shifts and the real interest rate. a. rightward; rises b. rightward; falls c. leftward; rises d. leftward; falls e. leftward; does not change 9. In Figure 10.2, has increased and the equilibrium quantity of loanable funds. a. wealth; increases b. default risk; increases c. expected profit; decreases d. expected future income; decreases e. disposable income; increases Complete the graph 1. Figure 10.3 shows a demand for loanable funds curve. a. Because the economy enters an expansion, the expected profit increases. Show the effect of this change on the demand for loanable funds curve in Figure 10.3.

8 142 Part 3. THE REAL ECONOMY loanable funds curve in Figure b. What is the equilibrium real interest rate? What is the equilibrium quantity of loanable funds? c. Suppose that firms become more optimistic about their expected profit. In Figure 10.5, show this change. What is the effect on the real interest rate and quantity of loanable funds and investment? 2. Figure 10.4 shows a supply of loanable funds curve. a. Suppose disposable income increases. Show the effect of this change on the supply of loanable funds curve in Figure b. Suppose wealth increases. Show the effect of this change on the supply of loanable funds curve in Figure Real interest rate (percent per year) Demand for loanable funds (trillions of 2005 dollars) Supply of loanable funds (trillions of 2005 dollars) The table above gives a supply of loanable funds schedule and a demand for loanable funds schedule. a. Label the axes and draw the supply of loanable funds curve and the demand for Short answer and numeric questions 1. What is the relationship between investment and the demand for loanable funds? 2. Why does an increase in the real interest rate decrease the quantity of loanable funds demanded? 3. What factors shift the demand for loanable funds curve? The supply of loanable funds curve? 4. If the real interest rate is less than its equilibrium value, what forces drive it to its equilibrium? Additional Exercises (also in MyEconLab Test A) In 2013, the Lee family had a disposable income of $80,000, wealth of $140,000, and an expected future income of $80,000 a year. At a real interest rate of 4 percent a year, the Lee family saves $15,000 a year; at a real interest rate of 6 percent a year, they save $20,000 a year; and at a real interest rate of 8 percent, they save $25,000 a year. Use this information to answer Exercises 1 and Draw a graph of the Lee family s supply of loanable funds curve. 2. In 2014, suppose that the stock market crashes and the Lee family s wealth decreases by 50 percent. Explain how this decrease in wealth influences the Lee family s supply of loanable funds curve. 3. Draw graphs that illustrate the effect of an increase in the demand for loanable funds and an even larger increase in the supply of loanable funds on the real interest rate and the equilibrium quantity of loanable funds.

9 Chapter 10. Finance, Saving, and Investment 143 CHECKPOINT 10.3 Explain how a government budget surplus or deficit influences the real interest rate, investment, and saving. Quick Review Crowding-out effect The tendency for a government budget deficit to raise the real interest rate and decrease investment. Additional Practice Problems The table shows the demand for loanable funds schedule and the private supply of loanable funds schedule. a. If the government s budget is balanced (so there is Real Demand Supply of interest for loanable loanable rate funds funds (percent (trillions of 2005 dollars per year) per year) no budget deficit nor budget surplus), what is the equilibrium real interest rate, the equilibrium the quantity of loanable funds, and the quantity of investment? b. If the government budget surplus is $200 billion, and there is no Ricardo-Barro effect, what are the equilibrium real interest rate, the quantity of private saving, and the quantity of investment? c. If the government budget deficit is $200 billion, and there is no Ricardo-Barro effect, what are the equilibrium real interest rate, the quantity of private saving, and the quantity of investment? Is there any crowding out? d. If the Ricardo-Barro effect occurs, how do your answers to part (b) and part (c) change? How does the equilibrium real interest rate and quantity of investment in these two cases compare to your answer to part (a)? 2. With a Ricardo-Barro effect, what is the impact of a government budget deficit or surplus? Does the size of the deficit or surplus matter? Solutions to Additional Practice Problems a. With no budget deficit or surplus, private saving is the total supply of loanable funds and private investment is the total demand for loanable funds. The equilibrium real interest rate is 7 percent a year. The equilibrium quantity of loanable funds is $2.4 trillion. Investment also is $2.4 trillion. 1b. When the government has a $200 billion budget surplus, it is adding that amount to private saving. At the initial real interest rate of 7 percent, there is a surplus of loanable funds. The real interest rate falls. When the real interest rate falls to 6 percent, the quantity of private saving is $2.3 trillion and the total quantity of loanable funds is $2.5 trillion. The quantity of loanable funds demanded is also $2.5 trillion so this real interest is the equilibrium. The equilibrium real interest rate is 6 percent, the equilibrium quantity of private saving is $2.3 trillion, and the equilibrium quantity of investment is $2.5 trillion. 1c. If the government has a $200 billion deficit, the demand for loanable funds at every real interest rate is $200 billion more than the private demand for loanable funds shown in the table. The equilibrium real interest rate is 8 percent because at this interest rate, the total quantity of loanable funds supplied, $2.5 trillion, equals the total quantity of loanable funds demanded. Private saving is $2.5 trillion and investment is $2.3 trillion. In comparison to the situation with no government deficit, $100 billion of investment has been crowded out. 1d. If the Ricardo-Barro effect occurs, then when the government has a $200 billion surplus in part (b), private saving decreases by $200 billion. As a result, the supply of loanable funds does not change. In this case, the equilibrium real interest rate is 7 percent, the quantity of private saving is $2.2 trillion, and the quantity of investment remains $2.4 trillion. When the government has a deficit of $200 billion in part (c), private saving increases by $200 billion so the supply of loanable funds increases. The equilibrium real interest rate is

10 144 Part 3. THE REAL ECONOMY 7 percent, the quantity of private saving is $2.6 trillion, and the quantity of investment remains $2.4 trillion. 2. The Ricardo-Barro effect says that government deficits and surpluses do not matter. Private saving changes to offset the budget deficit or surplus. Whether a deficit or surplus is large or small is inconsequential because it does not change the real interest rate or the quantity of investment. Self Test 10.3 Fill in the blanks Total saving equals private saving (plus; minus) government saving. A government budget surplus (increases; decreases) government saving. The crowding-out effect is the tendency for a government budget deficit to (increase; decrease) private investment. The Ricardo-Barro effect says that an increase in the government deficit will lead to (an increase; a decrease) in private saving. True or false 1. Governments do not participate in the loanable funds market. 2. With no Barro-Ricardo effect, an increase in government saving leads to a fall in the real interest rate. 3. With no Barro-Ricardo effect, an increase in government saving leads to an increase in the quantity of investment. 4. The crowding-out effect is the tendency of a government budget surplus to crowd out private saving. 5. The Ricardo-Barro effect holds that the government budget deficit has no effect on the real interest rate or investment. Multiple choice 1. With no Ricardo-Barro effect, a government budget surplus a. increases the supply of loanable funds. b. increases the demand for loanable funds. c. decreases the supply of loanable funds. d. decreases the demand for loanable funds. e. has no effect on either the supply or the demand for loanable funds. 2. Suppose the government has a budget surplus. Then a. private saving is equal to investment. b. private saving is greater than investment and government saving is positive. c. private saving is less than investment and government saving is positive. d. private saving is greater than investment and government saving is positive. e. private saving is greater than investment and government saving is negative. 3. With no Ricardo-Barro effect, a government budget surplus the real interest rate because the loanable funds increases. a. raises; demand for b. lowers; demand for c. raises; supply of d. lowers; supply of e. None of the above answers are correct because the real interest rate does not change. 4. If there is no Ricardo-Barro effect, a government budget deficit will the real interest rate and the quantity of investment. a. raise; increase b. raise; decrease c. lower; increase d. lower; decrease e. not change; not change

11 Chapter 10. Finance, Saving, and Investment The crowding-out effect refers to how a government budget deficit a. shifts only the supply of loanable funds curve leftward. b. shifts only the demand for loanable funds curve leftward. c. shifts both the demand for and the supply of loanable funds curves leftward. d. decreases the equilibrium quantity of investment. e. increases the equilibrium quantity of investment. 6. The Ricardo-Barro effect says that a government budget deficit leads to a. a higher real interest rate. b. a lower real interest rate. c. no change in the real interest rate. d. an increase in demand for loanable funds. e. an increase in the quantity of investment. Complete the graph Real interest rate (percent per year) Demand for loanable funds (trillions of 2005 dollars) Supply of loanable funds (trillions of 2005 dollars) The above table has a supply of loanable funds schedule and a demand for loanable funds schedule. a. In Figure 10.6 label the axes. Assuming there is no government saving, draw the supply of loanable funds curve and the demand for loanable funds curve. b. If the government has no budget deficit or surplus, what is the equilibrium real interest rate and quantity of investment? c. If the government has a $1.0 trillion deficit, and there is no Ricardo-Barro effect, draw the demand for loanable funds curve in Figure What is the equilibrium real interest rate and quantity of investment? d. If the government has a $1.0 trillion defi- cit, and there is a Ricardo-Barro effect, draw the demand for loanable funds curve in Figure What is the equilibrium real interest rate and quantity of investment? Short answer and numeric questions 1. What is the crowding-out effect? 2. How does the Ricardo-Barro effect modify the conclusion of the crowding-out effect? 3. The Eye on Your Life discussed some of the many transactions you will make in the loanable funds markets. Many students are financing part or all of their college educations by using student loans. How does the decision to finance a college education using student loans compare to a firm s decision to finance a new piece of capital equipment by using loans? Additional Exercises (also in MyEconLab Test A) Real interest rate (percent per year) Loanable funds demanded Loanable funds supplied (trillions of 2005 dollars per year) In the loanable funds market set out in the table above, the demand for loanable funds increases by $1 trillion at each real interest rate and the supply of loanable funds increases by $2 trillion

12 146 Part 3. THE REAL ECONOMY at each interest rate. Suppose there is no Ricardo-Barro effect. 1. If the government budget is balanced, what are the real interest rate, the quantity of loanable funds, investment, and private saving? Is there any crowding out in this situation? 2. If the government budget deficit is $1 trillion, what are the real interest rate, the quantity of loanable funds, investment, and private saving? (Recall that there is no Ricardo-Barro effect.) Is there any crowding out in this situation? 3. If the government wants to stimulate the quantity of investment and increase it to $9 trillion, what must it do?

13 Chapter 10. Finance, Saving, and Investment 147 SELF TEST ANSWERS CHECKPOINT 10.1 Fill in the blanks Finance and money are not essentially the same thing. Physical capital consists of tools, instruments, machines, buildings, and other items that have been produced in the past and that are used to produce goods and services. Net investment equals gross investment minus depreciation. A stock is a certificate of ownership and claim to the profit that a firm makes. Fannie Mae is an example of a government-sponsored mortgage lender. If other things remain the same, an increase in the price of an asset lowers the interest rate on the asset. True or false 1. False; page True; page True; page False; page True; page False; page 242 Multiple choice 11. b; page c; page c; page b; page d; page d; page e; page b; page b; page 242 Short answer and numeric questions 1. Physical capital is the tools, machines, buildings, and other items that have been produced in the past and are used to produce additional goods and services. Financial capital is the funds firms use to buy and operate physical capital. Hence a firm needs financial capital in order to buy a piece of physical capital; page Capital is the tools, machines, buildings, and other items that have been produced in the past and are used to produce additional goods and services. Investment is the purchase of new capital, so investment adds to the total amount of capital. Gross investment is the total amount of investment spent on new capital goods; page Regis gross investment was $33,000, and net investment, which equals gross investment minus depreciation, was $20,000; page Fannie Mae and Freddie Mac are government-sponsored enterprises. They both buy and sell in financial markets. On the buying side, they buy mortgages from banks. They then package these mortgages into mortgage-backed securities and sell them to others, such as pension funds; page The interest rate equals the (amount paid) (price of the asset) 100. In the first case in the problem, the interest rate is ($40) ($600) 100, which is 6.67 percent. When the price rises to $800, the interest rate falls to ($40) ($800) 100, or 5.00 percent.; page 242. Additional Exercises (also in MyEconLab Test A) 1. Annie s gross investment during 2012 was $100,000 because she sold some of her capital. Annie s depreciation during 2012 was $0. Annie s net investment during 2012 was $100,000, which equals gross investment ( $100,000) minus depreciation ($0). Anne s capital equals her capital at the beginning of 2012, $300,000, plus her net investment in 2012, $100,000, so her capital at the end of 2012 was $200,000; pages Karrie s wealth increased by $1,000,000 in So her saving in 2012 was $1,000,000. (This point assumes no capital gains or losses on her stocks and bonds.) Her income after taxes was $1,500,000. Her consumption equals her income minus her saving, which is $1,500,000 $1,000,000 = $500,000; pages

14 148 Part 3. THE REAL ECONOMY CHECKPOINT 10.2 Fill in the blanks Other things remaining the same, the higher the real interest rate, the smaller the quantity of loanable funds demanded. An increase in expected profit increases the demand for loanable funds. Other things remaining the same, the higher the real interest rate, the greater the quantity of loanable funds supplied. An increase in saving increases loanable funds. The financial market is in equilibrium when the quantity of loanable funds supplied equals the quantity of loanable funds demanded. True or false 1. True; page False; page True; page True; page False; page 250 Multiple choice 11. a; pages 245, c; page e; page b; page b; pages c; page d; page d; pages 246, e; pages 248, 251 Complete the graph 1. a. The increase in expected profit increases investment and thereby increases the demand for loanable funds. The demand for loanable funds curve shifts rightward, from DLF0 to DLF1 in Figure 10.7; page a. An increase in disposable income increases saving and the supply of loanable funds curve shifts rightward, from SLF0 to SLF1 in Figure 10.8; pages b. An increase in wealth decreases saving and thereby decreases the supply of loan- able funds. The supply of loanable funds curve shifts leftward, in Figure 10.8 from SLF0 to SLF2; pages a. The axes are labeled and the curves are drawn in Figure The supply of loan-

15 Chapter 10. Finance, Saving, and Investment 149 able funds curve is SLF and the demand for loanable funds curve is DLF0; pages 245, 248. b. The equilibrium real interest rate is 5 percent a year. The equilibrium quantity of loanable funds is $2.0 trillion; page 250. c. The increase in the expected profit increases investment and shifts the demand for loanable funds curve rightward from DLF0 to DLF1. The real interest rate rises and the quantity of investment and loanable funds increase; page 251. Short answer and numeric questions 1. The demand for loanable funds comes from business investment, a government budget deficit, and international investment or lending. Of these three sources of demand, the largest is business investment, so it is the largest part of the demand for loanable funds; page The real interest rate is the opportunity cost of the funds used for investment. These funds might be borrowed or they might be the financial resources of the firm s owners. The opportunity cost of both sources is the real interest rate. In the case of borrowed funds, the real interest rate is the opportunity cost because it is what is really paid to the lender. In the case of the owners funds, the real interest rate is the opportunity cost because the funds could be loaned and earn the real interest rate. An increase in the real interest rate increases the opportunity cost of financing investment so the quantity of loanable funds demanded decreases; page The demand for loanable funds curve shifts when the expected profit changes. Technological change, changes in the phase of the business cycle, population growth, and subjective influences, that is, swings of optimism and pessimism, all change the expected profit and shift the demand for loanable funds curve. The supply of loanable funds curve shifts when disposable income, wealth, expected future disposable income; and default risk change; pages If the real interest rate is less than the equilibrium real interest rate, the quantity of loanable funds demanded exceeds the quantity of loanable funds supplied. Borrowers can t find all the loans they want, but lenders are able to lend all the funds they have available. So the real interest rate rises and the quantity of loanable funds demanded decreases, while the quantity of loanable funds supplied increases. The equilibrium occurs when the interest rate is such that quantity of loanable funds demanded equals the quantity of loanable funds supplied; page 250. Additional Exercises (also in MyEconLab Test A) 1. The graph showing the Lee family s supply of loanable funds curve is in Figure 10.10; page A stock market crash decreases the Lee family s wealth, so the Lee family increases its saving. The Lee family s supply of loanable funds increases and its supply of loanable funds curve shifts rightward; page The increase in the demand for loanable funds raises the real interest rate and increases the equilibrium quantity of loanable funds. The increase in the supply of loanable funds lowers the real interest rate and increases the equilibrium quantity of loanable funds. If the change in the supply of loanable funds exceeds the change in the demand for loanable funds, the real interest rate falls. Both changes increase the equilibrium quan-

16 150 Part 3. THE REAL ECONOMY Multiple choice 1. a; page c; pages d; pages b; pages d; page c; page 256 Complete the graph tity of loanable funds, so the equilibrium quantity of loanable funds increases. Figure illustrates this situation. The increase in the demand for loanable funds shifts the demand for loanable funds curve rightward from DLF0 to DLF1. The increase in the supply of loanable funds shifts the supply of loanable funds curve rightward from SLF0 to SLF1. As Figure shows, the real interest rate falls, from 6 percent a year to 5 percent a year. The equilibrium quantity of loanable funds increases, from $2.1 trillion to $2.3 trillion; page 251. CHECKPOINT 10.3 Fill in the blanks Total saving equals private saving plus government saving. A government budget surplus increases government saving. The crowding-out effect is the tendency for a government budget deficit to decrease private investment. The Ricardo-Barro effect says that an increase in the government deficit will lead to an increase in private saving supply. True or false 1. False; page True; pages True; pages False; page True; page a. Figure labels the axes and plots the curves. The supply of loanable funds curve is labeled PSLF. With no government budget surplus, this curve is the same as the overall supply of loanable funds curve. The demand for loanable funds curve is labeled PDLF. With no government budget deficit, this curve is the same as the overall demand for loanable funds curve; page 255. b. If the government has no budget deficit or surplus, then in Figure the supply of loanable funds curve is the same as the supply of loanable funds curve labeled PSLF and the demand for loanable funds curve is the same as the demand for loanable funds curve labeled PDLF. The equilibrium real interest rate is 6 percent a year and the equilibrium quantity of loanable funds, which is the equilibrium quantity of investment, is $2.0 trillion; page 255.

17 Chapter 10. Finance, Saving, and Investment 151 c. With the government budget deficit and no Ricardo-Barro effect, the total quantity of loanable funds demanded equals the quantity of investment plus the government budget deficit of $1.0 trillion. Using this result, the total demand for loanable funds is labeled DLF in Figure This curve equals the private demand for loanable funds curve plus an additional $1.0 trillion at every real interest rate. The equilibrium real interest rate is 7 percent, the equilibrium quantity of loanable funds is $2.5 trillion, and the quantity of investment decreases to $1.5 trillion; pages d. With a $1.0 trillion government deficit, the Ricardo-Barro effect asserts that private saving increases by the amount of the deficit. So at every interest rate, the quantity of loanable funds is $1 trillion more than the amount given in the table. The total supply of loanable funds curve with the Ricardo-Barro effect is SLF in Figure The equilibrium real interest rate is 5 percent, the equilibrium quantity of loanable funds is $3.0 trillion, and investment is $2.0 trillion. This amount of investment is the same as in part (a); page 256. Short answer and numeric questions 1. The crowding-out effect is the tendency for a government budget deficit to decrease private investment. It occurs because a government deficit increases the demand for loanable funds, thereby raising the real interest rate and decreasing investment; pages The Ricardo-Barro effect says that private savers increase their saving in response to a government budget deficit. Private saving offsets any change in government saving. In this case, a government budget deficit has no effect on the equilibrium quantity of loanable funds, investment, or the equilibrium real interest rate; page The decision to finance a college education using loans is very similar to a firm s decision to finance a piece of capital equipment using loans. In both cases, the payoff from the purchase occurs throughout the future and the payments for the purchase are also made throughout the future. A business, of course, looks at the expected future profit from the capital before the business buys it. Similarly, one of the benefits from a college education is higher future income. These are reasons why a college education is said to help develop a person s human capital. Additional Exercises (also in MyEconLab Test A) 1. The real interest rate is 6 percent, and the quantity of loanable funds, private saving, and investment are all $8.5 trillion. There is no crowding out; page The equilibrium real interest rate becomes 7 percent. The equilibrium quantity of loanable funds is $9.0 trillion, the equilibrium quantity of investment is $8.0 trillion, and the equilibrium quantity of private saving is $9.0 trillion. There is crowding out of $500 billion of investment; pages Assuming no Ricardo-Barro effect, the government needs to have a budget surplus of $1 trillion. In this case, the new equilibrium real interest rate is 5 percent, the quantity of investment is $9 trillion, and the quantity of private saving is $8 trillion; pages

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