THINKING AND PROBLEM SOLVING

Question 9.24

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.”)

199

Question 9.25

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 9.26

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 9.27

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 9.28

  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.

    200

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

Question 9.29

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 9.30

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 9.31

Consider Figure 9.10. 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 9.32

“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 9.33

  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 9.34

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 9.35

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%.