Download Section 5 Homework: Questions Answer Key 2. a. When Rupert

Section 5 Homework: Questions Answer Key
2. 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.
b. When Rhonda Moviestar spends $10 million to buy a mansion built in the 1970s,
she is investing in a physical asset; she has bought something that she has the right
to use or to dispose of as she wishes. It is not an example of investment spending
because it does not add to the stock of physical capital in the economy—the
mansion was pre-existing.
c. When Ronald Basketballstar spends $10 million to
build a new mansion with a view of the Pacific Ocean, he has engaged in investment
spending because he has added to the amount of housing in the economy.
d. When Rawlings builds a new plant to make catcher’s mitts, it has engaged in
investment spending because it has added to the economy’s stock of physical capital.
e. When the government of Russia buys $100 million in U.S. government bonds, it
has invested in a financial asset. The Russian government has a paper claim on the
United States that entitles it to future income. It is not an example of investment
spending because it does not add to the stock of physical capital in either economy.
3. 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 of making financial deals incurred by either lenders or borrowers. (2) It
reduces the risk associated with making investments or engaging in investment
spending. (3) By increasing the liquidity of financial assets, it makes saving and the
purchasing of financial assets more attractive to potential lenders, which increases
investment spending.
4. 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’
primary assets) and resell shares of the portfolio composed of those stocks to
individual investors. Pension funds are a type of mutual fund that hold financial
assets of other companies (the pension funds’ primary assets) and sell shares to
individual savers for retirement income. A life insurance company also holds
financial assets (the life insurance company’s primary assets) and sells policies that
guarantee a payment to a policyholder’s beneficiary when the policyholder dies. A
bank makes loans to individuals and corporations (the bank’s primary assets) and
accepts deposits from the public that are payable on demand. By either reducing
risk through diversification (mutual funds, pension funds), reducing risk through
insurance (life insurance companies), lowering transaction costs (mutual funds,
pension funds), or providing liquidity (banks), these financial intermediaries
facilitate savings and investment spending.
5. a. Shares of stock are not a component of either M1 or M2, so holding fewer
shares does not decrease either M1 or M2. However, depositing the money into your
savings account increases M2, since the savings account is part of M2 (but not part
of M1). M1 does not change.
b. Shares of stock are not a component of either M1 or M2, and so holding fewer
shares does not decrease either M1 or M2. However, depositing the money into your
checking account increases M1, since checking accounts are part of M1. It also
increases M2, since M1 is part of M2.
c. Moving money from savings to checking has no effect on M2, since both savings
accounts and checking accounts are included in M2. However, since savings
accounts are not part of M1, moving money from savings to checking does increase
M1.
d. Depositing cash into a checking account does not change M1 or M2. You are
simply transferring money from one component of M1 (currency in circulation) to
another component of M1 (checkable deposits).
e. Depositing $0.25 into your
savings account has no effect on M2, since both savings accounts and currency in
circulation are in M2. However, since savings accounts are not part of M1,
depositing the $0.25 into your savings account reduces M1.
6. a. A bottle of rum is commodity money since the rum has other uses.
b. Salt is commodity money since it has other uses.
c. The “Rye Mark” is commodity-backed money since its ultimate value is
guaranteed by a promise that it can be converted into valuable goods (rye grain).
d. Ithaca HOURS are fiat money because their value derives entirely from their
status as a means of payment in Ithaca.
8. The NPV of $1 million now is $1 million. The NPV of $1.2 million paid out over
2
time is as follows: $300,000 + $300,000/1.20 + $300,000/(1.20) +
3
$300,000/(1.20) = $300,000 + $250,000 + $208,333.33 + $173,611.11 =
$931,944.44. It is better to receive your prize as a $1 million payment now, since the
high interest rate makes the net present value of $1.2 million paid out over time less
than $1 million.
10. a. Initially, the bank’s reserves rise by $500, as do its checkable deposits. There is
no initial change in the money supply; currency in circulation has fallen by $500 but
checkable deposits have increased by $500.
Assets Liabilities Reserves +$500 Checkable Deposits +$500
b. The bank will hold $50 as reserves against the new deposit and make additional
loans equal to $450.
c. The money supply can expand by $4,500. When Tracy
deposits $500, the bank now holds $450 in excess reserves. This will ultimately lead
to an increase in the money supply of $450/0.1 = $4,500.
d. The money supply can expand by $9,500. When Tracy deposits $500, the bank
now holds $475 in excess reserves. This will ultimately increase the money supply
by $475/0.05 = $9,500.
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 the government decreases its deficit. In response to the decrease in demand,
the interest rate falls from r1 to r2. This fall in interest rates will increase private
investment spending from Q3 to Q2 and decrease private savings from Q1 to Q2.
b. If consumers decide to save more, there will be an increase in the supply of
loanable funds. In the accompanying figure, this is represented by the rightward
shift of the supply curve from S1 to S2. The increase in the supply of loanable funds
reduces the equilibrium interest rate from r1 to r2. In response to the lower interest
rate, private investment spending will rise from Q1 to Q2.
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 equilibrium
interest rate from r1 to r2. In response to the higher interest rate, private savings
will rise from Q1 to Q2.
19. 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 in private savings of $100 billion, and private investment spending will
fall by $100 billion. Through the rise in the interest rate, the increase in government
borrowing crowded out $100 billion in private investment spending.
22. 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%.
However, with an actual inflation rate of 4%, an 8% nominal interest rate yields a
real interest rate of 4% (8% − 4% = 4%). So, in real terms, Boris pays more, and
Lynn receives more, than was expected.
b. If the actual inflation rate is 7%, Boris is better off and Lynn is worse off. Boris
had expected to pay, and Lynn had expected to receive, a real interest rate of 3%.
However, with an actual inflation rate of 7%, an 8% nominal interest rate yields a
real interest rate of 1% (8% − 7% = 1%). So, in real terms, Boris pays less, and Lynn
receives less, than was expected.
24. In the accompanying diagram, both the money market and the loanable funds
market are initially in equilibrium at the same rate of interest, r1. A decrease in the
money supply shifts the money supply curve leftward, to MS2, and the equilibrium
interest rate rises to r2. The increase in the interest rate leads to a decrease in real
GDP, which generates a decrease in savings through the multiplier process. This
decrease in savings shifts the supply curve for loanable funds leftward, to S2.
Consequently, the equilibrium interest rate in the loanable funds market rises. The
new equilibrium interest rate in the loanable funds market equals the rate in the
money market because savings fall by exactly enough to match the fall in investment
spending.