Download ECON 102 Tutorial: Week 11

ECON 101 Tutorial: Week 16
Shane Murphy
[email protected]
Office Hours: Monday 3:00-4:00 – LUMS C85
Outline
• Roll Call
• Problems
• Game
Chapter 24: Problem 3
Declines in share prices are sometimes viewed as
harbingers of future declines in real GDP. Why do
you suppose that might be true?
Stock prices are viewed as harbingers of future
declines in real GDP because people value stocks
based on the expected future profitability of the
firm. If stock prices fall, this must mean that
investors expect a lower future profitability for the
firms. This means that we might expect output in
these firms to decline as well.
Chapter 24: Problem 4
When the Greek government asked for support from the
EU to repay bonds that were coming up for maturity
between 2008 and 2010, interest rates rose on bonds
issued by a number of other EU countries like Portugal,
Spain, and Ireland also rose. Why do you suppose this
happened? What can you predict happened to the price
of bonds from these countries during this period?
When the Greek government asked for support on its
debt, investors perceived a higher chance of default
(than they had before) on similar bonds sold by other
EU countries like Spain, Ireland and Portugal. Since
investors believe they are less likely to earn back their
investment in a bond, they will want a higher interest
rate on the bond if they are to make an investment.
Chapter 24: Problem 4
When the Greek
government asked for
support on its debt,
investors perceived a
higher chance of default
(than they had before) on
similar bonds sold by
other EU countries like
Spain, Ireland and
Portugal. Thus the supply
of loanable funds shifted
to the left, as shown in
Figure 1. The result was
an increase in the
interest rate.
Chapter 24: Problem 7
Suppose GDP is €5 trillion, taxes are €1.5 trillion, private saving
is €0.5 trillion and public saving is €0.2 trillion. Assuming this
economy is closed, calculate consumption, government
purchases, national saving and investment.
We know that Y = 5, T = 1.5, Sprivate = 0.5 = Y - T - C, Spublic =
0.2 = T - G.
Since Sprivate = Y - T - C, then rearranging gives C = Y - T Sprivate = 5 - 1.5 - 0.5 = 3.
Since Spublic = T - G, then rearranging gives G = T - Spublic =
1.5 - 0.2 = 1.3.
Since S = national saving = Sprivate + Spublic = 0.5 + 0.2 = 0.7.
Finally, since I = investment = S, I = 0.7.
Chapter 24: Problem 7
Suppose GDP is €5 trillion, taxes are €1.5 trillion,
private saving is €0.5 trillion and public saving is €0.2
trillion. Assuming this economy is closed, calculate
consumption, government purchases, national
saving and investment.
Chapter 24: Problem 8
Suppose BP is considering exploring a new oil field
a. Assuming BP needs to borrow in the bond market
to finance the purchase of new machinery, why
would an increase in interest rates affect BPP’s
decision about whether to carry out the exploration?
If interest rates increase, the costs of borrowing
money to invest in the oil field exploration become
higher, so the returns from the exploration may not
be sufficient to cover the costs. Thus, higher interest
rates make it less likely that BP will undertake the
exploration.
Chapter 24: Problem 8
b. If BP has enough of its own funds
to develop the new field without
borrowing, would an increase in the
interest rate still affect BP’s decision?
Even if BP uses its own funds to
finance the exploration, the rise in
interest rates still matters. There is
an opportunity cost in using the
funds. Instead of investing in the
factory, BP could use the money to
buy bonds to earn the higher interest
rate available there. BP will compare
its potential returns from oilfield
exploration to the potential returns
from the bond market. So if interest
rates rise, so that bond market
returns rise, BP is again less likely to
invest in the exploration.
Chapter 24: Problem 9
Suppose the government borrows €5 billion more next year than
this year.
a. Use supply and demand to analyze this policy, does interest rate
rise or fall?
Initially, the supply of loanable funds is
curve S1, the equilibrium real interest
rate is i1, and the quantity of loanable
funds is L1. The increase in government
borrowing by €5 billion reduces the
supply of loanable funds at each
interest rate by €5billion, so the new
supply curve, S2, is shown by a shift to
the left of S1 by exactly €5 billion. As a
result of the shift, the new equilibrium
real interest rate is i2. The interest rate
has increased as a result of the
increase in government borrowing.
Chapter 24: Problem 9
b. What happens to investment, to private savings, to
public savings, and to national savings. Compare these
changes to the €5 billion change in government
borrowing.
Since the interest rate has increased, investment and
national saving decline, and private saving increases.
The increase in government borrowing reduces public
saving. From the figure you can see that equilibrium
level of loanable funds (and thus both investment and
national saving) decline by less than €5 billion, while
public saving declines by €5 billion and private saving
rises by less than €5 billion.
Chapter 24: Problem 9
c. How does the elasticity of the supply of loanable funds affect the
size of these changes
The more elastic is the supply of loanable funds, the flatter the supply
curve would be, so the interest rate would rise by less and thus
national saving would fall by less, as Figure 3 shows.
Chapter 24: Problem 9
d. How does the elasticity of the demand for loanable funds affect the
size of these changes
The more elastic the demand for loanable funds, the flatter the
demand curve would be, so the interest rate would rise by less and
thus national saving would fall by more, as Figure 4 shows.
Chapter 24: Problem 9
e. Suppose households believe that greater government
borrowing implies higher future taxes to pay the debt. What
does this belief do to private savings and the supply of
loanable funds?
If households believe that greater government borrowing
today implies higher taxes to pay off the government debt in
the future, then people will save more so they can pay the
higher future taxes, so private saving will increase, as will the
supply of loanable funds. This will offset the reduction in
public saving, thus reducing the amount by which the
equilibrium quantity of investment and national saving
decline, and reducing the amount that the interest rate rises. If
the rise in private saving was exactly equal to the increase in
government borrowing, there would be no shift in the national
saving curve, so investment, national saving, and the interest
rate would all be unchanged. (This is the case of Ricardian
equivalence.)
Chapter 24: Problem 10
This chapter explains that investment can be increased
both by reducing taxes on private savings and by
reducing the government budget deficit.
a. Why is it difficult to implement both of these policies
at the same time?
Investment can be increased by reducing taxes on
private saving or by reducing the government budget
deficit. But reducing taxes on private saving has the
effect of increasing the government budget deficit,
unless some other taxes are increased or government
spending is reduced. So it is difficult to engage in both
policies at the same time.
Chapter 24: Problem 10
b. What would you need to know about private saving in order
to judge which of these two policies would be a more effective
way to raise investment?
To know which of these policies would be a more effective way
to raise investment, you would need to know: (1) what the
elasticity of private saving is with respect to the posttax real
interest rate, since that would determine how much private
saving would increase if you reduced taxes on saving; (2) how
private saving responds to changes in the government budget
deficit, since, for example, if Ricardian equivalence holds, the
decline in the government budget deficit would be matched by
an equal decline in private saving, so national saving would not
increase at all; and (3) how elastic investment is with respect
to the interest rate, since if investment is quite inelastic,
neither policy will have much of an impact on investment.
Game
• http://sffed-education.org/chairman/
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