Chapter 26

1,
a, The bond of an eastern European government would pay a higher interest rate than the
bond of the U.S. government because there would be a greater risk of default.
b, A bond that repays the principal in 2040 would pay a higher interest rate than a bond that
repays the principal in 2020 because it has a longer term to maturity, so there is more risk to
the principal.
c, A bond from a software company you run in your garage would pay a higher interest rate
than a bond from Coca-Cola because your software company has more credit risk.
d, A bond issued by the federal government would pay a higher interest rate than a bond
issued by New York State because an investor does not have to pay federal income tax on the
bond from New York State.
2, Companies encourage their employees to hold stock in the company because it gives the
employees the incentive to care about the firm's profits, not just their own salaries. Then, if
employees see waste or see areas in which the firm can improve, they will take actions that
benefit the company because they know the value of their stock will rise as a result. It also
gives employees an additional incentive to work hard, knowing that if the firm does well,
they will profit.

But from an employee's point of view, owning stock in the company for which she or he
works can be risky. The employee's wages or salary is already tied to how well the firm
performs. If the firm has trouble, the employee could be laid off or have her or his salary
reduced. If the employee owns stock in the firm, then there is a double whammy¾the
employee is unemployed or gets a lower salary and the value of the stock falls as well. So
owning stock in your own company is a risky proposition. Most employees would be better
off diversifying¾owning stock or bonds in other companies¾so their fortunes would not
depend so much on the firm for which they work.
3,
a, When your family takes out a mortgage and buys a new house, that is investment because
it is a purchase of new capital.
b, When you use your $200 paycheck to buy stock in AT&T, that is saving because your
income of $200 is not being spent on consumption goods.
c, When your roommate earns $100 and deposits it in his account at a bank, that is saving
because the money is not spent on consumption goods.
d, When you borrow $1,000 from a bank to buy a car to use in your pizza-delivery business,
that is investment because the car is a capital good.
4,
- Consumption: 6
- Government Purchases: 1.3
- National Saving: 0.7
- Investment: 0.7
5,
- Private Saving: 2500
- Public Saving: -200
- National Saving: 2300
- Investment: 2300
- Equilibrium Real Interest Rate: 10%
6,
a, If interest rates increase, the costs of borrowing money to build the factory become higher,
so the returns from building the new plant may not be sufficient to cover the costs. Thus,
higher interest rates make it less likely that Intel will build the new factory.
b, Even if Intel uses its own funds to finance the factory, the rise in interest rates still matters.
There is an opportunity cost on the use of the funds. Instead of investing in the factory, Intel
could use the money to purchase bonds and earn the higher interest rate available there. Intel
will compare its potential returns from building the factory to the potential returns from the
bond market. If interest rates rise, so that bond market returns rise, Intel is again less likely to
invest in the factory.
7,
a, For this problem, we can use the future value equation posted below, knowing that we only
want to know the return in 1 year and that borrowing and lending are prohibited.
FV = (1+r) x PV
Where FV is future value, r is rate of return, and PV is present value:
Harry FV = (1+0.05) x $1000 = $1050
Ron FV = (1+0.08) x $1000 = $1080
Hermione FV = (1+0.20) x $1000 = $1200
8,
a, Figure 1 illustrates the effect of the $20 billion increase in government borrowing. Initially,
the supply of loanable funds is curve S1, the equilibrium real interest rate is i1, and the
quantity of loanable funds is L1. The increase in government borrowing by $20 billion
reduces the supply of loanable funds at each interest rate by $20 billion, so the new supply
curve, S2, is shown by a shift to the left of S1 by exactly $20 billion. As a result of the shift,
the new equilibrium real interest rate is i2. The interest rate has increased as a result of the
increase in government borrowing.
b, Because the interest rate has increased, investment and national saving decline and private
saving increases. The increase in government borrowing reduces public saving. From the
figure you can see that total loanable funds (and thus both investment and national saving)
decline by less than $20 billion, while public saving declines by $20 billion and private
saving rises by less than $20 billion.
c, The more elastic is the supply of loanable funds, the flatter the supply curve would be, so
the interest rate would rise by less and thus national saving would fall by less, as Figure 2
shows.
d, . The more elastic the demand for loanable funds, the flatter the demand curve would be,
so the interest rate would rise by less and thus national saving would fall by more, as Figure 3
shows.
e, If households believe that greater government borrowing today implies higher taxes to pay
off the government debt in the future, then people will save more so they can pay the higher
future taxes. Thus, private saving will increase, as will the supply of loanable funds. This will
offset the reduction in public saving, thus reducing the amount by which the equilibrium
quantity of investment and national saving decline, and reducing the amount that the interest
rate rises.
9,
a, When taxes on private saving fall, government revenue is likely to fall.
To reduce the government budget deficit, either taxes go up or government revenue goes
down. Now since taxes are already falling, you'd need a large fall in government spending to
occur to have these 2 policies at the same time.
b, What you'd need to know is how responsive is private saving to tax cuts.
Government spending is a direct competitor to investment, they are both competing for a pool
of savings as source of financing. Hence every dollar that is not spent by the government is a
dollar that could be available for private investment at the given interest rates.

However, if taxes on saving are lowered, the effect is not necessarily 1-1. The consumer has
the choice whether to save all the taxes he/she is not paying (in which case the effect would
be 1-1) or whether the consumer would want to spend some of it (which is more likely) and
make less available for private investment.