Chapter 10 Boris And Lynn Who Better Off The

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Solution

S-135

1. Given the following information about the closed economy of Brittania, what is the

level of investment spending and private savings, and what is the budget balance?

What is the relationship among the three? Is national savings equal to investment

spending? There are no government transfers.

1. In a closed economy, investment spending is equal to GDP minus consumer spending

minus government purchases of goods and services. In Brittania, investment spending

is $50 million:

I = GDP − C − G

I = $1,000 million − $850 million − $100 million = $50 million

2. Given the following information about the open economy of Regalia, what is the level of

investment spending and private savings, and what are the budget balance and net capi-

tal inflow? What is the relationship among the four? There are no government transfers.

2. In an economy with capital inflows or outflows, investment spending is equal to GDP

minus consumer spending minus government purchases of goods and services plus

net capital inflow, the value of imports minus the value of exports. In Regalia, invest-

CHAPTER

Savings, Investment Spending,

and the Financial System

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Solution

S-136 CHAPTER 10 SAVINGS, INVESTMENT SPENDING, AND THE FINANCIAL SYSTEM

Private savings and the budget balance are measured in the same way regardless of

whether or not there are capital inflows or outflows. (Again, recall that there are no

government transfers.) In Regalia, private savings is $100 million and the budget bal-

ance is −$50 million (that is, the government is running a deficit of $50 million):

3. The accompanying table shows the percentage of GDP accounted for by private sav-

ings, investment spending, and net capital inflow in the economies of Capsland and

Marsalia. Capsland is currently experiencing a positive net capital inflow and Marsalia,

a negative net capital outflow. What is the budget balance (as a percentage of GDP) in

both countries? Are Capsland and Marsalia running a budget deficit or surplus?

3. In both countries, investment spending as a percentage of GDP must be equal to the

sum of private savings, the budget balance, and net capital inflow as a percentage of

GDP. We can calculate the budget balance as investment spending minus the sum of

private savings and net capital inflow:

Capsland Marsalia

Investment spending as a

percentage of GDP 20% 20%

Solution

CHAPTER 10 SAVINGS, INVESTMENT SPENDING, AND THE FINANCIAL SYSTEM S-137

4. Assume the economy is open to capital inflows and outflows and therefore net capital

inflow equals imports (IM) minus exports (X). Answer each of the following questions.

a. X = $125 million

IM = $80 million

Budget balance = −$200 million

I = $350 million

Calculate private savings.

4. According to the savings–investment spending identity in an economy open to capital

flows from and to abroad, the following must hold: I = Private savings + Budget bal-

ance + (IM − X). We use this to solve for the missing variable in each problem.

a. $350 million = Private savings − $200 million + ($80 million − $125 million)

So private savings = $595 million

5. The accompanying table, taken from the National Income and Product Accounts Tables,

shows the various components of U.S. GDP in 2012 and 2013 in billions of dollars.

Gross Government Government Net government

domestic Private Gross domestic purchases of savings (budget taxes after

product consumption investment goods and services balance) transfers

Year (billions of dollars)

2012 $16,163.2 $11,083.1 $2,479.2 $2,549.7 −$1,311.7 ?

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Solution

5. a. Because savings by the government is equal to the difference between the tax rev-

enue that it collects (after transfers) and current government purchases of goods

and services, the table can be completed as shown below.

b. In 2012, taxes (after transfers) as a percentage of GDP were 7.7%, and in 2013,

10.0%. This can be found by dividing taxes (after transfers) by GDP.

c. National and private savings for 2012 and 2013 are listed in the accompanying

table. Private savings is equal to disposable income, that is, income after taxes and

6. The government is running a budget balance of zero when it decides to increase

education spending by $200 billion and finance the spending by selling bonds. The

accompanying diagram shows the market for loanable funds before the government

sells the bonds. Assume that there are no capital inflows or outflows. How will the

equilibrium interest rate and the equilibrium quantity of loanable funds change? Is

there any crowding out in the market?

24%

Interest

rate

Government Government Net

Gross Gross purchases savings government

domestic Private domestic of goods (budget taxes after

Year product consumption investment and services balance) transfers

(billions of dollars)

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Solution

6. The $200 billion in government borrowing will increase the demand for loanable

funds from D1 to D2 as shown in the accompanying diagram. The equilibrium interest

rate rises from 10% to 12%, and the equilibrium quantity of loanable funds increases

from $500 billion to $600 billion. The rise in the interest rate will lead to an increase

7. In 2014, Congress estimated that the cost of increasing support and expanding pre-

kindergarten education and infant and toddler childcare would cost $28 billion. Since

the U.S. government was running a budget deficit at the time, assume that the new

pre-K funding was financed by government borrowing, which increases the demand

for loanable funds without affecting supply. This question considers the likely effect of

this government expenditure on the interest rate.

a. Draw typical demand (D1) and supply (S1) curves for loanable funds without the

7. a. The demand for loanable funds without government borrowing to finance the

expanded pre-K programs is shown in the accompanying diagram.

Interest

rate

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Solution

Interest

rate

$28 billion

8. Explain why equilibrium in the loanable funds market maximizes efficiency.

8. Equilibrium in the loanable funds market maximizes efficiency because it ensures that

investment spending projects with higher rates of return get funded before those with

9. How would you respond to a friend who claims that the government should eliminate

all purchases that are financed by borrowing because such borrowing crowds out pri-

vate investment spending?

9. You might first acknowledge that, other things equal, when the government runs a

budget deficit, there is an increase in the demand for loanable funds. The increase in

10. Boris Borrower and Lynn Lender agree that Lynn will lend Boris $10,000 and that

Boris will repay the $10,000 with interest in one year. They agree to a nominal inter-

est rate of 8%, reflecting a real interest rate of 3% on the loan and a commonly

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Solution

10. a. If the actual inflation rate is 4%, Lynn is better off and Boris is worse off. Boris

had expected to pay, and Lynn had expected to receive, a real interest rate of 3%.

11. Using the accompanying diagram, explain what will happen to the market for loan-

able funds when there is a fall of 2 percentage points in the expected future inflation

rate. How will the change in the expected future inflation rate affect the equilibrium

quantity of loanable funds?

Interest

rate

11. In the accompanying diagram, the market for loanable funds is initially in equilib-

rium at E1, with a nominal interest rate of 8%. A fall of 2 percentage points in the

expected future inflation rate leads, by the Fisher effect, to a fall of 2 percentage

points in the nominal interest rate to 6%. The real interest rate and the equilibrium

quantity of loanable funds remain unchanged. The change in expected inflation

causes both a downward shift of the supply curve for loanable funds, from S1 to S2,

and a downward shift of the demand curve for loanable funds, from D1 to D2.

Interest

rate

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Solution

12. The accompanying diagram shows data for the interest rate on 10-year euro area gov-

ernment bonds and inflation for the euro area for 1996 through mid-2014, as report-

ed by the European Central Bank. How would you describe the relationship between

the two? How does the pattern compare to that of the United States in Figure 10-8?

10-year euro bond

rate, euro area

inflation rate

Interest rate

Inflation rate

12. As in the case of the United States in panel (a) of Figure 10-8, the euro area experi-

ence is largely one of low and relatively constant inflation. As expectations of future

inflation declined, so did interest rates during the first part of the period illustrated

in the accompanying diagram. Based on the expectation of continuing low inflation,

13. For each of the following, is it an example of investment spending, investing in finan-

cial assets, or investing in physical assets?

a. Rupert Moneybucks buys 100 shares of existing Coca -Cola stock.

13. a. When Rupert Moneybucks buys 100 shares of existing Coca-Cola stock, he is

investing in a financial asset. He has a paper claim that entitles him to future

income from Coca-Cola. It is not an example of investment spending because it

does not add to the stock of physical capital in the economy.

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Solution

14. Explain how a well-functioning financial system increases savings and investment

spending, holding the budget balance and any capital flows fixed.

14. A well-functioning financial system increases both the supply of loanable funds and

the demand for loanable funds in three ways. (1) It reduces the transaction costs

15. What are the important types of financial intermediaries in the U.S. economy? What

are the primary assets of these intermediaries, and how do they facilitate investment

spending and saving?

15. Mutual funds, pension funds, life insurance companies, and banks are the most

important types of financial intermediaries in the U.S. economy. Mutual funds are

companies that buy stocks of other companies (the mutual funds companies’ pri-

16. Explain the effect on a company’s stock price today of each of the following events,

other things held constant.

a. The interest rate on bonds falls.

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Solution

16. a. Because bonds are a substitute asset for stocks, this will lead to a rise in all stock

prices, including this company’s stock price.

b. This will lead to an immediate rise in the company’s stock price because it is unex-

17. Sallie Mae is a quasi-governmental agency that packages individual student loans into

pools of loans and sells shares of these pools to investors as Sallie Mae bonds.

a. What is this process called? What effect will it have on investors compared to situ-

ations in which they could only buy and sell individual student loans?

17. a. By pooling individual loans and selling shares of those pools as bonds, Sallie Mae

has engaged in securitization. Because the likelihood that a default by one student is

usually unrelated to, or independent from, the likelihood of default by some other

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Solution

18. Use the market for loanable funds shown in the accompanying diagram to explain what

happens to private savings, private investment spending, and the interest rate if each of

the following events occur. Assume that there are no capital inflows or outflows.

a. The government reduces the size of its deficit to zero.

18. a. If the government reduces its deficit to zero, there will be a decrease in the demand

for loanable funds, from D1 to D2, equal to the reduction in the size of the deficit.

In the accompanying figure, the amount Q1 − Q3 represents the amount by which

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b. If consumers decide to save more, there will be an increase in the supply of loan-

able funds. In the accompanying figure, this is represented by the rightward shift of

c. Higher investment spending at any given interest rate leads to an increase in

the demand for loanable funds. In the accompanying figure, the increase in the

demand for loanable funds shifts the demand curve from D1 to D2 and raises the

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