Investment, Saving, and the Real Interest Rate

10 Investment, Saving, and the Real Interest Rate CHAPTER CHECKPOINTS

Checkpoint 10.1 Checkpoint 10.2 Checkpoint 10.3 Problem 1 Problem 1 Problem 1 Problem 2 Clicker version Problem 2 Problem 2 Problem 3 Problem 3

Practice Problem 1 Michael is an Internet service provider. On December 31, 2007, he bought an existing business with servers and a building worth $400,000. During his first year of operation, his business grew and he bought new servers for $500,000. The market value of some of his older servers fell by $100,000. What was Michael’s gross investment, depreciation, and net investment during 2008 and what is Michael’s capital at the end of 2008? CHECKPOINT 10.1

Solution Michael’s gross investment during 2008 was $500,000—the market value of the new servers he bought. Michael’s depreciation during 2008 was $100,000—the fall in the market value of some of his older servers. Michael’s net investment during 2008 was $400,000. Net investment equals gross investment minus depreciation, which is ($500,000  $100,000). CHECKPOINT 10.1

The capital grew during 2008 by the amount of net investment. Michael’s net investment during 2008 was $400,000. So that at the end of 2008, capital was $400,000 + $400,000, which equals $800,000. CHECKPOINT 10.1

Practice Problem 2 Lori earns $20,000 after paying her taxes. At the beginning of 2007, Lori owned $1,000 worth of books, CDs, and golf clubs and she had $5,000 in a savings account at the bank. During 2007, the interest on her savings account was $300 and she spent $15,300 on consumption goods. The market values of her books, CDs, and golf clubs did not change. How much did Lori save in 2007? What was her wealth at the end of 2007? CHECKPOINT 10.1

Solution Lori saved $5,000. Saving equals income (after tax) minus the amount spent. That is, Lori’s saving equaled $20,300 minus $15,300, which is $5,000. Lori’s wealth at the end of 2007 was $11,000—the sum of her wealth at the start of 2007 ($6,000) plus her saving during 2007 ($5,000). CHECKPOINT 10.1

Practice Problem 1 First Call, Inc. is a cellular phone company. It plans to build an assembly plant that costs $10 million if the real interest rate is 6 percent a year. If the real interest rate is 5 percent a year, First Call will build a larger plant that costs $12 million. And if the real interest rate is 7 percent a year, First Call will build a smaller plant that costs $8 million. Draw a graph of First Call’s demand for loanable funds curve. CHECKPOINT 10.2

Solution The demand for loanable funds curve is the blue downward-sloping curve DLF0 and passes through the points highlighted in the figure. CHECKPOINT 10.2

Practice Problem 2 First Call, Inc. is a cellular phone company. The graph shows its demand for loanable funds. First Call expects its profit to double next year. If other things remain the same, explain how this increase in expected profit influences First Call’s demand for loanable funds. CHECKPOINT 10.2

Solution An increase in the expected profit increases investment today, which increases the quantity of loanable funds demanded at each real interest rate. The demand for loanable funds curve shifts rightward to DLF1 in the figure. CHECKPOINT 10.2

Study Plan Problem First Call, Inc. expects its profit to double next year. If other things remain the same, First Call _________. A. increases the quantity of funds demanded along its demand for loanable curve. B. decreases its demand for loanable funds C. increases its demand for loanable funds D. decreases the quantity of funds demanded along its demand for loanable curve CHECKPOINT 10.2

Practice Problem 3 Draw a graph that illustrates how an increase in the supply of loanable funds and a decrease in the demand for loanable funds can lower the real interest rate and leave the equilibrium quantity of loanable funds unchanged. CHECKPOINT 10.2

Solution The increase in the supply of loanable funds shifts the supply curve rightward. The decrease in the demand for loanable funds shifts the demand curve leftward. The real interest rate falls. If the shifts are of the same magnitude, the equilibrium quantity of funds remains unchanged. CHECKPOINT 10.2

Practice Problem 1 The table shows the demand for loanable funds schedule and the private supply of loanable funds schedule. If the government budget surplus is $1 trillion, what are the real interest rate, the quantity of investment, and the quantity of private saving? Is there any crowding out? CHECKPOINT 10.3

Solution With a government budget surplus of $1 trillion, the total supply of loanable funds curve SLF. The equilibrium real interest rate is 6 percent a year and the quantity of loanable funds is $7.5 trillion. Investment is $7.5 trillion and private saving is $6.5 trillion. Crowding out does not occur. CHECKPOINT 10.3

Practice Problem 2 The table shows the demand for loanable funds schedule and the private supply of loanable funds schedule. If the government budget deficit is $1 trillion, what are the real interest rate, the quantity of investment, and the quantity of private saving? Is there any crowding out? CHECKPOINT 10.3

Solution With a government budget deficit of $1 trillion, the total supply of loanable funds curve SLF. The real interest rate is 8 percent a year, investment is $6.5 trillion, and private saving is $7.5 trillion. Crowding out occurs because the deficit raises the real interest rate, which decreases investment. CHECKPOINT 10.3

Practice Problem 3 The table shows the demand for loanable funds schedule and the private supply of loanable funds schedule. If the government budget deficit is $1 trillion and the Ricardo-Barro effect occurs, what are the real interest rate and the quantity of investment? CHECKPOINT 10.3

Solution If the Ricardo-Barro effect occurs, private saving adjusts to offset the budget deficit if $1 trillion. The equilibrium interest rate remains at 7 percent a year and investment is $7 trillion. Crowding out does not occur because government dissaving does not influence the real interest rate. CHECKPOINT 10.3

Investment, Saving, and the Real Interest Rate