PROBLEMS AND APPLICATIONS

I. For each of the following pairs, which bond would you expect to pay a higher interest rate? Explain.

a. a bond of the U.S. government or a bond of an East European government

b. a bond that repays the principal in year 2005 or a bond that repays the principal in year 2025

c. a bond from Coca-Cola or a bond from a software company you run in your garage.

d. a bond issued by the federal government or a bond issued by New York State

2. Theodore Roosevelt once said, “There is no moral difference between gambling at cards or in lotteries or on the race track and gambling in the stock market.” What social purpose do you think is served by the existence of the stock market?

3. When the Russian government defaulted on its debt to foreigners in 1998, interest rates rose on bonds issued by many other developing countries. Why do you suppose this happened?

4. Many workers hold large amounts of stock issued by the firms at which they work. Why do you suppose companies encourage this behavior? Why might a person not want to hold sock in the company where he works?

5. Explain the difference between saving and investment as defined by a macro economist. Which of the following situations represent investment? Saving? Explain.

a. Your family takes out a mortgage and buys a new house.

b. You use your $200 paycheck to buy stock in AT&T.

c. Your roommate earns $100 and deposits it in her account at a bank.

d. You borrow $1,000 from a bank to buy a car to use in your pizza delivery business.

6. Suppose GDP is $10 trillion, taxes are $2.0 trillion, private saving is $0.7 trillion, and public saving is -$0.1 trillion. Assuming this economy is closed, calculate consumption, government purchases, national saving, and investment.

7. Suppose. that Intel is considering building a new chip-making factory.

a. Assuming that Intel needs to borrow money in the bond market, why would an increase in interest rates affect Intel’s decision about whether to build the factory?

-b. If Intel has enough of its own funds to finance the new factory without borrowing, would an increase in interest rates still affect Intel’s decision about whether to build the factory? Explain.

8. Suppose the government borrows $20 billion more. next year than Use a supply-and-demand diagram to analyze this policy. Does the interest rate rise or fall?

b. What happens to investment? To private saving? To public saving? To national saving? Compare the size of the changes to the $20 billion of extra government borrowing.

c. How does the elasticity of supply of loan able funds affect the size of these changes?

d. How does the elasticity of demand for loan able funds affect the size of these changes?

e. Suppose households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future. What does this belief do to private saving and the supply of loan able funds today? Does it increase or decrease the effects you discussed in parts (a) and (b)?

9. Over the past decade, new computer technology has enabled firms to reduce substantially the amount of inventories they hold for each dollar of sales. Illustrate the effect of this change on the market for loan able funds. (Hint: Expenditure on inventories is a type of investment.) What do you think has been the effect on investment in factories and equipment?

10. “Some economists worry that the aging populations of industrial countries are going to start running down their savings just when the investment appetite of emerging economies is growing” (Economist, May 6, 1995). Illustrate the effect of these phenomena on the world market for loan able funds.

11. This chapter explains that investment can be increased both by reducing taxes on private saving and by reducing the government budget deficit.

a. Why is it difficult to implement both of these policies at the same time?

b. What would you need to know about private saving to judge which of these two policies would be a more effective way to raise investment?

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