Econ 1102: Recitation 5 ©Gina Pieters

Recitation #5

  1. Present and Future Value
  2. Saving and Investment
  3. Loanable Funds Market
  4. 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?
  1. 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
  1. What is the value of consumption in the economy above?
  1. What is the level of National Savings?
  1. What is the level of Private Savings?
  1. What is the level of Public Savings?

C.Loanable Funds Market

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?
  1. Will the amount of private loans increase or decrease?

D.Supply and Demand in the Market for Loanable Funds

  1. Suppose that the government decides to reduce taxes on interest earned from savings. What happens to interest rates and demand for loans?
  1. Sps the government decides to increase taxes on firm’s investments. What happens to interests rates and demand for loans?

Practice Problems

  1. Loanable Funds Market

Consider the following events. What is the effect on the loanable funds market (amount, interest rate)?

  1. 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.
  1. The MPC of an economy increases.
  1. The government passes a savings tax credit.
  1. 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:
  2. Due to foreign investment there is an increase in the supply of funds.
  1. 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.
  1. 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.
  1. The government passes a consumer protection act widely reported to decrease predatory lending by banks. Consumers feel safer about taking out more loans.
  1. 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.
  1. 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?
  1. Calculate the Future value of…
  1. $100 purchase of 1 year Tbill that pays 10% interest
  1. $100 purchase of 5 year Tbill that pays 10% interest
  1. $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.
  1. Calculate the Present value of…
  1. $102 in 1 year when the interest rate is 2%
  1. $500 in 3 years when the interest rate is 5%
  1. Consider the following closed economy (i.e. no trade, no net exports)

Investment (I) / $200
Taxes / $100
Consumption (C) / $500
Government Purchases (G) / -
Gross Domestic Product (Y) / $1000
  1. What is the value of Government Purchases in the economy above?
  1. What is the level of National Savings?
  1. What is the level of Private Savings?
  1. What is the level of Public Savings?

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