Chapter 18
Question 1:
a. The stability and creditworthiness of the US government make US government bonds extremely safe.
Investors would, however, demand a higher interest rate as recompense for taking on greater risk because
Eastern European countries might be more politically and economically vulnerable.
b. The longer the bond's maturity, the greater the degree of future uncertainty, and the higher the risk. To
make up for the extra time and uncertainty, a bond maturing in 2050 would typically offer a higher
interest rate.
c. Coca-Cola is a large, well-established company that has little credit risk and consistently makes money.
But, since a software business you run in your garage is likely a startup with higher risks (including
business unpredictability, financial instability, and a less proven track record), investors would expect a
higher interest rate to balance the additional risk.
d. Because the government has the authority to impose taxes and create money, U.S. federal government
bonds are thought to be the safest. In contrast to federal bonds, state government bonds, such as those
issued by the state of New York, usually offer a higher interest rate to offset the comparatively low level
of risk they carry.
Question 2:
Employee ownership of company stock is frequently encouraged by employers as a way to better align
employee interests with those of the business. Employees who own stock put in more effort and are more
devoted to the company because they care more about its success. Because they will wish to stay with the
company longer in order to hold the stock, talented personnel can also be retained with the help of stock.
Employees must, however, carefully weigh the dangers of owning business shares. Employees risk losing
both their jobs and their investment if they put all of their money into a single stock or if the company
experiences problems. To reduce risk, it is crucial to diversify the investment portfolio.
Question 3:
a. This represents investment. Purchasing a new house adds to the physical capital of the economy.
b. This represents saving. Buying stocks is a form of financial saving, not investment
c. This represents saving. Depositing money in a bank account is a typical way to save income.
d. This represents investment. The car is used as a productive asset to generate income, making it a
physical capital investment.
Question 4:
Consumption (C): C=Y−I−G=6C = Y - I - G = 6C=Y−I−G=6 (trillion USD)
Government purchases (G): G=T−Public saving=1.3G = T - Public saving=1.3 (trillion USD)
National saving (S): S=Private saving + Public saving=0.7 (trillion USD)
Investment (I): I=S=0.7I = S = 0.7I=S=0.7 (trillion USD)
Question 5:
Private saving: Y−T−C=10,000−1,500−6,000=2,500
Public saving: T−G=1,500−1,700=−200
National saving: Private saving + public saving =2,500+(−200) =2,300
Investment: I=S=2,300
Equilibrium real interest rate (r):
I(r)=3,300−100r
2,300=3,300−100r⇒r=10%
Question 6:
a. A higher interest rate raises the cost of debt, so if Intel takes out a loan, it will have to pay more in
interest. This raises the cost of the manufacturing, and if the expenses are more than the advantages, Intel
may decide to postpone or abandon the project.
b. Higher interest rates may make the plant investment less alluring even though they have no direct
effect on Intel's financing costs because
-Opportunity cost: By putting the money into financial assets (like bonds) rather than the manufacturing,
Intel may increase its profits.
-Economic impact: A slowdown in the economy could be indicated by rising interest rates, which would
diminish demand for Intel's products and the factory's anticipated profits.
Question 7:
a.
Harry: 1,000×(1+0.05)=1,050
Ron: 1,000×(1+0.08)=1,080
Hermione: 1,000×(1+0.20)=1,200
b. Students would choose to be a borrower
c.
At 7% interest rate:
Harry: Return = 5% (won't borrow; will lend).
Ron: Return = 8% (will borrow).
Hermione: Return = 20% (will borrow).
Quantity Supplied: Only Harry will lend, supplying $1,000.
Quantity Demanded: Ron and Hermione want to borrow. Since their combined demand exceeds Harry’s
supply, they’ll request $2,000 total.
At 10% interest rate:
Harry: Return = 5% (won't borrow; will lend).
Ron: Return = 8% (won’t borrow; will lend).
Hermione: Return = 20% (will borrow).
Quantity Supplied: Harry and Ron will lend, supplying $2,000.
Quantity Demanded: Only Hermione will borrow $1,000.
d. The loanable funds among the three would be equal at 8% interest. At this rate, Harry lends and
Hermione borrows.
e. Harry: $1,050
Ron: $1,080
Hermione: $1,320 (after repaying $1,080 loan)
Comparison with Part (a):
Harry: $1,050 (up from $1,000).
Ron: $1,080 (up from $1,000).
Hermione: $1,320 (up from $1,200).
Who Benefits?
Ron and Hermione, the borrowers, gain from more investment and increased returns.
Harry and Ron, the lenders, receive interest.
Nobody is in a worse situation.
Question 8:
a. Increased government borrowing shifts the demand for loanable funds right, raising the interest
rate.
b.
Investment decrease (borrowing is more expensive when interest rates are greater).
Private saving increase (saving is encouraged by higher rates).
Public saving decrease ($20 billion greater deficit).
National saving decrease
Because private saving increases but does not completely cover the deficit, the overall decline in national
saving is less than $20 billion.
c.
Greater supply elasticity results in a greater rise in private saving and a smaller increase in interest rates.
A smaller growth in private saving and a higher increase in interest rates are the results of less elastic
supply.
d.
Greater demand elasticity results in a greater decline in investment and a smaller increase in interest rates.
Less elastic demand results in a smaller decline in investment and a larger increase in interest rates.
e.
Households will raise their private savings today if they anticipate higher future taxes, which will correct
the quantity of loanable funds.
The interest rate increase is lessened as a result.
Compared to (a) and (b), the effect on national saving and investment is less pronounced.
Question 9:
a.
-Reductions in taxes on savings lower government revenue, which raises the budget deficit.
-Savings are discouraged since lowering the deficit frequently necessitates raising taxes or cutting
spending.
-Both of these policies are incompatible and difficult to implement at the same time.
b.
-Lowering saving taxes encourages investment if private saving reacts well to tax cuts
-Lowering the budget deficit is preferable if private saving is insensitive.
- Determining the optimal strategy is aided by researching saving behavior.
