Investment, Saving and Finance PDF

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Investment, Saving and Finance...

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Investment, Saving and Finance

Question 1: Identify each of the following acts as representing either saving or investment. a. Mohammed uses some of his income to buy government bonds. b. Mona takes some of her income and buys mutual funds. c. Said purchases a new truck for his delivery business using borrowed funds. d. Amina uses some of her income to buy stock in a major corporation. e. Huda hires a builder to construct a new building for her bicycle shop.

Question 2: What are the basic differences between bonds and stocks? Question 3: Comment on the following sentence. “Investment is a major component of short run demand and long run supply”.

Question 4: Suppose we are in a closed economy. Explain using national accounting equations, the role played by savings whether there is a budget surplus or a budget deficit. Question 5: Draw and label a graph showing equilibrium in the market for loanable funds. Question 6: Explain why the demand for loanable funds slopes downward and the supply of loanable funds slopes upward. Question 7: Suppose the market for loanable funds is in equilibrium at r*. The government institutes a tax on investment. Represent the new equilibrium r** on the market for loanable funds and comment. Question 8: 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?

Question 9: Suppose the government imposes a fixed interest rate r lower than the market equilibrium interest rate r*.

a) Describe the situation on the market for loanable funds. b) What could be the reaction of unsatisfied borrowers?

Question 10: Suppose the government satisfies everyone’s demand for loanable funds at the declared fixed interest rate like in question 5. What could be the consequences for the economy in the long run? Question 11 : Suppose the government decides to increase taxes on saving (via financial earnings) and investment in order to finance its increased spending. Using the diagram of the market for loanable funds, describe and comment on the new equilibrium.

Question 12 : Using a graph representing the market for loanable funds, show and explain what happens to interest rates and investment if a government goes from a deficit to a surplus.

Investment, Saving and Finance (Answers)

Question 1: Identify each of the following acts as representing either saving or investment. a. Mohammed uses some of his income to buy government bonds. b. Mona takes some of her income and buys mutual funds. c. Said purchases a new truck for his delivery business using borrowed funds. d. Amina uses some of her income to buy stock in a major corporation. e. Huda hires a builder to construct a new building for her bicycle shop. a. Mohammed is saving. b. Mona is saving. c. Said is investing. d. Amina is saving. e. Huda is investing Question 2: What are the basic differences between bonds and stocks? A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond, while stock represents a share of ownership in a firm and is, therefore, a claim on the profits that the firm makes. The sale of bonds to raise money is called debt finance, while the sale of stock is called equity finance. Whereas the owner of shares of stock in a company shares in the profits of a company, the owner of bonds receives a fixed interest rate. Compared to bonds, stocks offer the holder both higher risk and a potentially higher return. Question 3: Comment on the following sentence. “Investment is a major component of short run demand and long run supply”. In the short run: investment is a major component of GDP as it is more volatile than C, G or NX. It is therefore highly correlated with output and therefore unemployment. In the long run: investment determines the stock of capital per worker and therefore how productive the economy is.

Question 4: Suppose we are in a closed economy. Explain using national accounting equations, the role played by savings whether there is a budget surplus or a budget deficit. C+S+T=C+I+G simplifying into S=I+G-T. If G>T, which means there is a budget deficit, savings are used to finance private investment and the deficit. But this can be rewritten S+T-G=I in case there is a budget surplus, in which case private savings and public savings (the government budget surplus) are used to finance private domestic investment.

Question 5: Draw and label a graph showing equilibrium in the market for loanable funds.

Market for Loanable Funds

Question 6: Explain why the demand for loanable funds slopes downward and the supply of loanable funds slopes upward. When the interest rate rises investment spending becomes more expensive, so people invest less. As the interest rate rises saving becomes more rewarding, so people want to save more. The inverse relation between interest and borrowing is reflected in the downward slope of the demand for loanable funds curve. The positive relation between interest and saving is reflected in the upward slope of the supply of loanable funds curve.

Question 7: Suppose the market for loanable funds is in equilibrium at r*. The government institutes a tax on investment. Represent the new equilibrium r** on the market for loanable funds and comment.

The investment curve will shift to left. This translates into a new equilibrium characterized by lower equilibrium investment and interest rate. As on every market, each time demand decreases, the equilibrium traded quantity declines as for the price of this good.

Question 8: 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?

The claim that an increase in the interest rate decreases investment supposes that only the interest rate changes and everything else is constant. The investment tax credit causes investment to rise at each interest rate. As firms want to borrow more the interest rate will rise. The rise in interest rates does make investment less than it would otherwise be, but unless the supply of loanable funds is vertical, the increase in investment demand from the tax credit is larger than the decrease in investment demand from the rising interest rate.

Question 9: Suppose the government imposes a fixed interest rate r lower than the market equilibrium interest rate r*. a) Describe the situation on the market for loanable funds. b) What could be the reaction of unsatisfied borrowers? There will rationing on the market for loanable funds as the demand for funds exceeds supply. Letting market mechanisms work freely, there would be an increase in the interest rate bringing it to a level such that demand matches supply. Unsatisfied borrowers can try to find money outside the domestic money market or on the black market.

Question 10: Suppose the government satisfies everyone’s demand for loanable funds at the declared fixed interest rate like in question 5. What could be the consequences for the economy in the long run?

If the interest rate is structurally too low, there will be over-borrowing and therefore overspending. If prices are free, this will soon translate into higher inflation. Question 11: Suppose the government decides to increase taxes on saving (via financial earnings) and investment in order to finance its increased spending. Using the diagram of the market for loanable funds, describe and comment on the new equilibrium. Both the investment and savings curves will shift to the left, translating into a lower equilibrium investment. As for the new equilibrium interest rate, it depends on whether borrowers or lenders will be more affected by these taxes. Question 12: Using a graph representing the market for loanable funds, show and explain what happens to interest rates and investment if a government goes from a deficit to a surplus. As shown in the graph below, the economy starts in equilibrium at point E0 with interest rate r0 and equilibrium quantity of saving and investment at q0. If the government succeeds in obtaining a surplus, there will be more public saving in the economy and so more national saving at each interest rate, and the supply of loanable funds curve will shift from S0 to S1. The new equilibrium will be at E1, with a lower interest rate, r1 and a higher quantity of saving and investment, q1. Hence, if the federal government succeeds in having a surplus, interest rates will fall and investment will increase.

Market for Loanable Funds...