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Econ 1102: Recitation 5
©Gina Pieters
Recitation #5
A.
B.
C.
D.
Present and Future Value
Saving and Investment
Loanable Funds Market
Supply and Demand in the Market for Loanable Funds
A. Present and Future Value
1. Suppose you invest $500 at an real interest rate of 8%? What is your real yield after 1 year?
2. Suppose you win the lottery. The lottery will pay you $5000 2 year from now. The current real
interest rate is 2%. What is that $5000 worth to you today?
B. Saving and Investment
Consider the following closed economy
Investment (I)
$ 150
Taxes minus Transfers (T)
$200
Consumption (C)
Government Purchases (G)
$300
Gross Domestic Product (Y)
$500
a. What is the value of consumption in the economy above?
b. What is the level of National Savings?
c. What is the level of Private Savings?
d. What is the level of Public Savings?
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Econ 1102: Recitation 5
©Gina Pieters
C. Loanable Funds Market
Interest Rate
Loan Supply
0.75%
0.50%
0.25%
Loan Demand
$50
$100
$150
Suppose the country is in a recession, and the government wants to follow an expansionary fiscal policy.
Unfortunately, tax revenue doesn’t cover the additional spending, forcing the government to go into
debt.
1. Which one of the two lines above (demand or supply) does this affect? Is the new equilibrium
interest rate higher or lower?
2.
Will the amount of private loans increase or decrease?
D. Supply and Demand in the Market for Loanable Funds
Interest
Rate (%)
5%
2%
1
3
5
Qty of Loanable Funds (bil) ($)
a. Suppose that the government decides to reduce taxes on interest earned from
savings. What happens to interest rates and demand for loans?
b. Sps the government decides to increase taxes on firm’s investments. What
happens to interests rates and demand for loans?
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Econ 1102: Recitation 5
©Gina Pieters
Practice Problems
1. Loanable Funds Market
Consider the following events. What is the effect on the loanable funds market (amount, interest rate)?
a. Government increases purchases, G, and increases taxes, T enough so that the budget
remains balanced. Consumers don’t change consumption, C, and GDP doesn’t change.
b. The MPC of an economy increases.
c. The government passes a savings tax credit.
d. Consider a more realistic market, where both firms and consumers are allowed to take out
loans. Graph and explain what happens the equilibrium amount of loans and interest rate as
the following sequence of events unfolds:
i.
Due to foreign investment there is an increase in the supply of funds.
ii.
There is a financial crisis caused by a bubble in the stock market, so that a portion of the
supplied funds simply “disappears” and supply shifts to the left.
iii.
Consumers and firms become hesitant to take out additional loans after the financial
crisis, because they don’t know if they’ll be able to repay them.
iv.
The government passes a consumer protection act widely reported to decrease
predatory lending by banks. Consumers feel safer about taking out more loans.
v.
In order to meet the new standards of the government law, banks must spend more
“effort” in screening customers. As a result, the supply of loans decreases.
vi.
Look at your graph and determine if the new interest rate and loanable funds demand is
higher or lower than the one in scenario (a). How will changing the elasticity of the
loanable fund supply and demand will change your answer?
2. Calculate the Future value of…
a. $100 purchase of 1 year Tbill that pays 10% interest
b. $100 purchase of 5 year Tbill that pays 10% interest
c. $100 purchase of stocks in a company after 1 year when the company has 20% chance of
bankruptcy, making the stocks worthless, 15% chance of stagnation, stocks neither gain nor
lose value, 60% chance the stocks give a 2% real interest and 5% change the stocks give 300%
real interest.
3. Calculate the Present value of…
a. $102 in 1 year when the interest rate is 2%
b. $500 in 3 years when the interest rate is 5%
4. Consider the following closed economy (i.e. no trade, no net exports)
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Econ 1102: Recitation 5
©Gina Pieters
Investment (I)
$200
Taxes
$100
Consumption (C)
$500
Government Purchases (G)
Gross Domestic Product (Y)
$1000
a. What is the value of Government Purchases in the economy above?
b. What is the level of National Savings?
c. What is the level of Private Savings?
d. What is the level of Public Savings?
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