CHAPTER REVIEW

FACTS AND TOOLS

Question 29.14

1. If people want to smooth their consumption over time, what will they tend to do when they win the lottery: spend most of it within a year or save most of it for later?

Question 29.15

2. A large number of economic and psychological studies demonstrate that people who are impatient in one area of their life tend to be impatient in other areas as well. This isn’t true in every single case, but of course, that doesn’t matter if we’re trying to understand the “typical person.” Based on your general knowledge and educated guessing:

  1. Who is more likely to smoke: a criminal or a law-abiding citizen?

  2. Who is more likely to shoot heroin: a person who saves 20 percent of their income or a person who can’t ever find a way to save?

  3. Who is more likely to have a lot of credit card debt: a smoker or a nonsmoker?

Question 29.16

3. The typical savings supply curve has a positive slope. If a nation’s saving supply curve had a perfectly vertical slope, what would that mean?

  1. People in this country save the same amount no matter what the interest rate is.

  2. People in this country are extremely sensitive to interest rates when deciding how much to save.

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Question 29.17

4. Consider three countries: Jovenia (average age: 25), Mittelaltistan (average age: 45), and Decrepetia (average age: 75). Based on the lifecycle theory, which of these countries will probably have:

  1. High savings rates?

  2. High rates of borrowing?

  3. High rates of dissaving? (That’s spending your past savings.)

    Note: The way for entire countries to save is to build up the stock of productive capital either at home (through high investment rates) or abroad (by exporting more than importing, i.e., running a trade surplus, and using the proceeds to buy foreign investment goods and assets).

Question 29.18

5. Sometimes, in supply and demand models, it’s not clear who “supplies” and who “demands.” For instance, in the labor market, individual workers (not firms) supply labor. In the loanable funds market, who is usually the supplier and who is usually the demander? Choose the correct answer.

  1. Entrepreneurs supply loanable funds and savers demand loanable funds.

  2. Entrepreneurs supply loanable funds and savers also supply loanable funds.

  3. Entrepreneurs demand loanable funds and savers demand loanable funds.

  4. Entrepreneurs demand loanable funds and savers supply loanable funds.

Question 29.19

6. In each of the following, answer either “bank account,” “bonds,” or “stocks.”

  1. Which investment is typically the riskiest?

  2. Which is a corporate IOU?

  3. Which one gives you an ownership “share” in a company?

  4. Which one usually lets you “withdraw” part of your investment at any time, for any reason?

  5. Which form of investment usually spreads your money over the largest number of investment projects?

  6. Which is usually rated by private companies like Moody’s or Standard and Poor’s?

  7. Which one is offered by the U.S. government as well as by private corporations?

Question 29.20

7. If savers don’t feel safe putting their money in banks or buying bonds, what’s the best way to sum up what’s happening in the market for loanable funds?

  1. Supply of savings falls and the interest rate falls.

  2. Supply of savings falls and the interest rate rises.

  3. Demand for savings falls and the interest rate falls.

  4. Demand for savings falls and the interest rate rises.

Question 29.21

8. When governments outlaw high interest rates and the ceiling is binding, what probably happens to the total amount of money borrowed?

  1. It rises because borrowers are protected from high interest rates.

  2. It falls because savers aren’t willing to lend as much money at this low interest rate.

  3. Both a and b are usually true.

Question 29.22

9. If financial intermediation breaks down, what category of GDP will probably fall the most: consumption, investment, government purchases, or net exports?

Question 29.23

10.

  1. In a competitive banking system, what tends to happen to banks that make low-interest rate loans to the banker’s friends: Do they tend to be more successful or less successful than other, more ruthless banks?

  2. Given your answer to the previous question, how do you suspect that politicized government-owned banks stay in business?

THINKING AND PROBLEM SOLVING

Question 29.24

1. Let’s work out a simple example in which a person smooths her consumption over time. Gwen is a real estate agent, and she knows that she will have some good years and some bad years. She figures that half the time she’ll earn $90,000 per year, and half the time she’ll earn $20,000 per year. These numbers are after taxes and after saving for retirement. These numbers are all she has to worry about.

  1. If we ignore interest costs just to keep things simple, how much should Gwen consume in the average year?

  2. How many dollars will she save during the good years?

  3. How many dollars will she borrow during the bad years? (Note: “Borrowing,” in this context, is basically the same as “pulling money out of savings.”)

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Question 29.25

2. Let’s think about how the supply of savings might shift in two different cases.

  1. Under current U.S. law, businesses are allowed to automatically enroll you in a savings plan that puts 5% of your salary in a retirement fund. Suppose Congress abolishes this law: Draw the appropriate shift in the supply curve and label it “a.”

  2. If Americans all go to see the classic Robin Williams/Ethan Hawke film Dead Poets Society and decide to carpe diem, or if they read the quotes of a famous Mediterranean preacher who said, “Take therefore no thought for the morrow,” or if they watch the appalling 1970s sitcom One Day at a Time, what direction is the supply of savings likely to shift? Denote this with a new supply curve labeled “b.”

Question 29.26

3. In this chapter, we focus on three big functions that banks perform:

  1. They evaluate business ideas to see to whom it’s worth lending.

  2. They spread an investment’s risk among many different projects.

  3. They make it easier for people to make payments through checks, ATMs, and wire transfers.

    None of these functions are unique to banks. In the following anecdotes, is the person doing function i, function ii, or function iii?

  1. Emmanuel donates a little money to five different charities, in the hopes that at least one of them will do some good in the world.

  2. In Lorien’s family, she’s the one who specializes in deciding which bank everyone else in the family will use.

  3. Popeye always has a little cash on hand, so he is always able to lend a little money to Wimpy and Olive Oyl at lunchtime.

  4. George spends his time at the Carlyle Group deciding which companies are worth his investment partners’ dollars.

  5. Scooter wants a good education, so he takes a variety of different classes: some history, some economics, some physics.

  6. Frances subscribes to Consumer Reports to decide which washing machine to buy.

Question 29.27

4. In many poor countries, the banking system just isn’t advanced enough to lend money for many large investments. Based on this single fact, where would you expect to see more entrepreneurs coming from rich families rather than poor families: in the rich countries or the poor countries? Why?

Question 29.28

5.

  1. The financial analysts at Lexmark have evaluated five major projects. Each project, if it actually goes forward, will be financed by going to a bank to borrow the money. They’ve calculated a “break-even interest rate”: If they can borrow cash to pay for the project at less than that rate, the project will likely be a success; if the rate is higher, then it’s not worth it.

     

    Cost

    Break-even Interest Rate

    Project A

    $100 million

      8%

    Project B

      $50 million

    12%

    Project C

    $200 million

    50%

    Project D

      $25 million

      4%

    Project E

    $150 million

    10%

  1. If the interest rate is 11%, which projects will Lexmark take on? If the market interest rate is 6%, which projects will it take on?

  2. Let’s turn this information into a demand curve for loanable funds.

    Organize this data to convert it into Lexmark’s “loanable funds demand” curve.

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    Note: It will look just like an ordinary demand curve, only with more breaks.

Question 29.29

6. In each of the three cases, which bond will usually pay a higher interest rate?

  1. A bond rated AAA, or a bond rated BBB?

  2. A U.S. government bond, or a General Motors bond?

  3. A Citibank bond that gets repaid in 30 years or a Citibank bond that gets repaid in 1 year?

Question 29.30

7. Consider your answers to the previous question. When one bond pays a higher interest rate than another bond, is that mostly because savers are less willing to supply loanable funds to the higher-rate bond, or because businesses are more interested in demanding loanable funds for the higher-rate bond? Why is this so?

Question 29.31

8. Consider Figure 29.10. Would a rise in government borrowing make it harder or easier for a new business to sell new stocks in an initial public offering (IPO)? In other words, are government bonds and corporate stocks substitutes for each other or complements to each other?

Question 29.32

9. “If the government keeps real interest rates low (either by raising inflation or by decreeing low interest rates), then this encourages extra borrowing by businesses, which leads to more investment purchases, a larger stock of capital equipment, and higher productivity. Therefore, an interest rate ceiling is a good idea.” What’s wrong with this argument?

Question 29.33

10.

  1. If a zero-coupon bond with a face value of $1,000 payable in 1 year sells for $925, what is the interest rate?

  2. If another bond with the same face value and maturity sells for $900, what is the interest rate on this bond?

  3. Which bond, the one discussed in question a or question b, would you rather invest in? Are you sure? Think again!

Question 29.34

11. Rank the following loans in order from low risk/low return, to high risk/high return.

  1. 30-year fixed rate home loan

  2. 5-year CD issued by the local FDIC-insured bank

  3. 13-week U.S. Treasury bill

  4. Capital One credit card held by an unemployed high school dropout.

  5. 30-year bond issued by AAA-rated company Johnson & Johnson

  6. 10-year bond issued by AAA-rated company Johnson & Johnson

Question 29.35

12. Using a spreadsheet and the material in the appendix, answer the following questions.

  1. Assume the interest rate is 5% (0.05). Calculate the value of a bond that pays $100 at the end of every year for the next 9 years and then at the end of the 10th year pays $1000.

  2. Calculate the value of this bond if the interest rate is 3%.

CHALLENGES

Question 29.36

1. The United States borrows a lot of money from other countries. If you wanted to use the lifecycle theory to explain this, would you say that the United States is acting like a “young” country, an “old” country, or a “middle-aged” country? There’s more than one correct way to answer this question.

Question 29.37

2. Lenders are more willing to lend if the borrower can put up collateral for the loan. Remember that collateral is something of value that by agreement becomes the property of the lender if the borrower defaults. In the United States, many small business owners borrow money for their business by using their houses or business assets as collateral. But in many developing countries, people don’t have secure property rights, or title, to the land or house in which they live. In Bangalore, India, for example, it’s nearly impossible to say who owns a piece of land and about 85% of the people in that city live on a piece of land for which they have no title. How difficult do you think it would be for a small business person in Bangalore to get a modest-sized loan?

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Question 29.38

3. Bank savings accounts typically pay an interest rate well below the inflation rate. As of spring 2011, for example, the best interest rates on savings accounts were around 1% per year, while the CPI inflation rate was around 2.5% per year. What does this mean about the real interest rate on bank savings? Knowing this, why would people still choose to deposit any money in bank savings accounts?

Question 29.39

4. How are houses like bonds? With respect only to their home equity (i.e., ignoring all other assets and investments), would homeowners tend to favor high or low interest rates?

Question 29.40

5. Answer the following question using a spreadsheet and the material in the appendix.

You would like to buy a house. Assume that given your income, you can afford to pay $12,000 a year to a lender for the next 30 years. If the interest rate is 7% how much can you borrow today based on your ability to pay? What about if the interest rate is 3%?

!launch! WORK IT OUT

Predict the effect of each of the following events on the supply of and demand for loanable funds (increase, decrease, or no effect on supply; increase, decrease, or no effect on demand). What would be the likely effect on interest rates?

  1. Television newscasters convince most people that the end of the world will occur in 2015.

  2. Breakthrough advances in pharmaceuticals increase life expectancy to 100 years.

  3. Geologists discover vast new oil deposits under the South Pole. (Hint: drilling in this harsh environment requires extremely large up-front capital expenses.)

  4. A business downturn leads to corporate pessimism and increases workers’ fears of being laid off (assume workers try to increase their “emergency fund” savings when they’re worried about becoming unemployed).

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