Saving, Investment, and the Financial System 6519
61. Suppose that you are a broker and people tell you the following about themselves. What sort of
bond would you recommend to each? Defend your choices.
a. “I am in a high federal income tax bracket and I don’t want to take very much risk.”
b. “I want a high return and I am willing to take a lot of risk to get it.”
c. “I want a decent return and I have enough deductions that I don’t value tax breaks highly.”
6520 Saving, Investment, and the Financial System
62. Your brother-in–law wants to buy either stock or bonds in Cedar Valley Furniture, which
manufactures wooden furniture. He wants your advice on whether to buy stock or bonds. Explain
how each of his quotes below should affect his choice between the stock and the bond.
a. “I have reason to believe that people are soon going to find rocking chairs have health
benefits.”
b. “I would like to tell people I am part owner of Cedar Valley Furniture.”
c. “I do not want to take on much risk.”
63. Suppose the Move It! exercise chain has revenues of $45 million, accounting costs of $15 million,
and currently has issued 10 million shares of stocks selling at $90 each. Compute the price-earning
ratio. Show your work. Is this ratio relatively high or low? What might an increase in the price-
earnings ratio indicate?
Saving, Investment, and the Financial System 6521
64. In the national income accounting identity showing the equality between national saving and
investment, what are the algebraic expressions for private saving and public saving?
65. Identify each of the following acts as representing either saving or investment.
a. Fred uses some of his income to buy government bonds.
b. Julie takes some of her income and buys mutual funds.
c. Alex purchases a new truck for his delivery business using borrowed funds.
d. Elaine uses some of her income to buy stock in a major corporation.
e. Henrietta hires a builder to construct a new building for her bicycle shop.
6522 Saving, Investment, and the Financial System
66. Draw and label a graph showing equilibrium in the market for loanable funds.
67. Explain why the demand for loanable funds slopes downward and why the supply of loanable
funds slopes upward.
Saving, Investment, and the Financial System 6523
68. The model of the market for loanable funds shows that an investment tax credit will cause
interest rates to rise and investment to rise. Yet we also suppose that higher interest rates lead to
lower investment. How can these two conclusions be reconciled?
6524 Saving, Investment, and the Financial System
69. Using a graph representing the market for loanable funds, show and explain what happens to
interest rates and investment if the government budget goes from a deficit to a surplus.
Saving, Investment, and the Financial System 6525
Problems
1. What is the main function of the financial system?
2. The financial system is important because it helps to match one person’s with another
person’s .
3. When someone borrows to purchase capital goods, he is using someone else’s to fund his .
6526 Saving, Investment, and the Financial System
4. What is a bond buyer promised when she buys a bond?
5. What does the maturity of a bond indicate?
6. A is a certificate of indebtedness and a is a claim to partial ownership in a firm.
7. A restaurant chain announces declining revenues. What’s the name of the type of risk that this
news raises for holders of this chain’s bonds? What does this news to do the interest rate on this
chain’s bonds?
Saving, Investment, and the Financial System 6527
8. Concerns about the bankruptcy of an appliance manufacturer diminish after a new CEO is
appointed and some of the company’s less productive factories are sold. What type of risk for
bondholders falls? What happens to the interest rate on this company’s bonds?
9. Bond A and Bond B have identical characteristics except that Bond A has a higher interest rate.
Which bond has a higher credit risk?
10. Bond A and Bond B are identical except Bond B has a longer term. Therefore, we expect Bond
_____ to pay a higher rate of interest.
6528 Saving, Investment, and the Financial System
11. Bonds issued by state and local governments are called _____ bonds. Bonds issued by
financially shaky corporations are called _____ bonds. Of these two, which type of bond usually
pays a relatively higher interest rate?
12. If federal tax rates increased, what would happen to the interest rate on municipal bonds?
13. List three characteristics of a bond that would make its interest rate higher than otherwise.
Saving, Investment, and the Financial System 6529
14. Stock in Frozen Dreams, an ice cream manufacturer, has a price to earnings ratio of 24. Is this
comparatively high or low? What are two explanations for the size of this company’s price to
earnings ratio?
15. How do banks make profits?
16. What is a mutual fund?