Questions for Review

1. What is the role of the financial system? The financial system helps to

match one person's saving with another person's investment. Name and

describe two (2) markets that are part of the financial system in the U.S.

economy. Two markets that are part of the financial system in the U.S.

economy are financial markets and financial intermediaries. Name and

describe two (2) financial intermediaries. Banks and mutual funds.

2. Why is it important for people who own stocks and bonds to diversify their

holdings? What type of financial institution makes diversification easier?

The value of any single stock or bond is tied to the fortunes of one

company, so holding a single kind of stock or bond is very risky. People

who hold a diverse portfolio of stocks and bonds face less risk because

they have only a small stake in each company. Mutual funds make this

diversification easy.
3. What is national saving? The total income in the economy that remains

after paying for consumption and government purchases. Denoted S; Y -

C - G = I; S = I What is private saving? The amount of income that

households have left after paying their taxes and paying for their

consumption. In particular, because households receive income of Y, pay

taxes of T, and spend C on consumption, private saving is Y - T - C. What

is public saving? The amount of tax revenue that the government has left

after paying for its spending = the difference between taxes and

government spending: T G How are these three (3) variables related?

National saving is the sum of private saving and public saving.

4. What is investment? Investment refers to the purchase of new capital,

such as equipment or buildings. How is it related to national saving in a

closed economy? It is equal to national saving. S=I

5. Describe a change in the tax code that might increase private saving. If

this policy were implemented, how would it affect the market for loanable

funds? A change in the tax code that might increase private saving is the

expansion of eligibility for special accounts that allow people to shelter

some of their saving from taxation.

This would increase the supply of loanable funds, lower interest rates, and

increase investment.
6. What is a government budget deficit? How does it affect interest rates,

investment, and economic growth? A government budget deficit arises

when the government spends more than it receives in tax revenue.

Because a government budget deficit reduces national saving, it raises

interest rates, reduces private investment, and thus reduces economic

growth.

Quick Check Multiple Choice

1. Nina wants to buy and operate an ice cream truck but doesn't have the

financial resources to start the business. She borrows $5000 from her

friend Max, to whom she promises an interest rate of 7%, and gets

another $10,000 from her friend David, to whom she promises a third of

her profits. What bests describes this situation?

a. Max is a stockholder, and Nina is a bondholder
b. Max is a stockholder, and David is a bondholder
 c. David is a stockholder, and Nina is a bondholder
d. David is a stockholder, and Max is a bondholder
2. If the government collects more in tax revenue than it spends, and

households consume more than they get in after-tax income, then

a. Private and public saving are both positive
b. Private and public saving are both negative
c. Private saving is positive, but public saving is negative
d. Private saving is negative, but public saving is positive
3. A closed economy has income of $1000, government spending of $200,

taxes of $150, and investment of $250. What is private saving?

a. $100
b. $200
c. $300
d. $400
4. If a popular TV show on personal finance convinces more Americans

about the importance of saving for retirement, the ______ curve for

loanable funds would shift, driving the equilibrium interest rate ______.
a. Supply, up
b. Supply, down
c. Demand, up
d. Demand, down
5. If the business community becomes more optimistic about the profitability

of capital, the ______ curve for loanable funds would shift, driving the

equilibrium interest rate ______.

a. Supply, up
b. Supply, down
c. Demand, up
d. Demand, down
6. From 2008 to 2012, the ratio of government debt to GDP in the United

States
a. Increase markedly.
b. Decrease markedly.
c. Was stable at a historically high level.
d. Was stable at a historically low level.

Problem and Applications

 1. For each of the following pairs, which bond would you expect to pay a

higher interest rate? Explain.

a. A bond of the United States government or a bond of an Eastern

European government. The US bond, because there is much more

confidence in the ability of the US government to honor its debt

commitments.
b. A bond that repays the principle in the year 2020 or a bond that repays

the principle in the year 2040.

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.

3. Explain the difference between saving and investment as defined by a

macroeconomist. To a macroeconomist, savings occur when a persons income

exceeds his consumption, while investment occurs when a person or firm

purchases new capital, such as a house or business equipment. Which of the

following situations represent investment? Saving? Explain.

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

It is an investment because it is a purchase of a new capital.
b. You use your $200 paycheck to buy stock in AT&T.
It is saving because your income of $200 is not being spent on

consumption goods.

c. Your roommate earns $100 and deposits to in his account at a bank.

It is saving because the money is not spent on consumption goods.

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

delivery business.
 It is investment because the car is a capital good.

4. Suppose GDP is $8 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.

Given that
Y = $8 T
T = $1.5 T
PS = $0.5T
Public Saving = $0.2T
Sprivate = 0.5 = Y -T - C,
Spublic = 0.2 = T - G.

Because Sprivate = Y - T - C,
then rearranging gives C = Y - T - Sprivate = 8 - 1.5 - 0.5 = 6.

Because Spublic = T - G,
then rearranging gives G = T - Spublic = 1.5 - 0.2 = 1.3.

Because S = national saving = Sprivate + Spublic = 0.5 + 0.2 = 0.7.

Finally, because I = investment = S, I = 0.7.