1. Economists in Funlandia, a closed economy, have collected the following information about the economy for a particular year:
Economists also estimate that the investment function is: where r is the country’s real interest rate, expressed as a percentage. Calculate private saving, public saving, national saving, investment, and the equilibrium interest rate. Please note: national savings is not related to the interest rate, which means that the supply curve for loanable funds is vertical. (15 points)
Private Savings= Y-T-C 10000-1500-6000= 2500
Public Saving= T-G 1500-1700= -200
National Saving= S=(Y-T-C)+(T-G)=(10000-1500-6000)+(1500-1700)= 2300 Investing= I=Y-C-G 10000-6000-1700= 2300
Real interest rate
I = 3,300-100r , 100r = 3,300-I
100r = 3,300-2300 ( I=2300)
100r = 1000
100r/100 = 1000/100 (dividing it by 100)
r = 10
2. In the summer of 2010, Congress passed a far-reaching financial reform to prevent another financial crisis like the one experienced in 2008-2009. Consider the following possibilities: a. Suppose that, by requiring firms to comply with strict regulations, the bill increases the costs of investment. On a well-labeled graph, show the consequences of the bill on the market for loanable funds.
Be sure to specify changes in the equilibrium interest rate and the level of saving and investment. What are the effects of the bill on long-run economic growth (recall: higher investment would increase capital and capital per worker)? (7 points) i. The demand loanable would decline along with the equilibrium. The saving and investments will decline as well
hence giving the economy a lower rate for the future. ii.
b. Suppose, on the other hand, that by effectively regulating the financial system, the bill increases savers’ confidence in the financial system. Show the consequences of the policy in this situation on a new graph, again noting changes in the equilibrium interest rate and the level of saving and investment. Again evaluate the effects on long run growth. (7 points) i. The supply of loanable funds would increase. The interest rate will decrease while the savings and investments will increase. Which will let the economy growth for the future, ii.
Problems for Chapter 14
3. According to an old myth, Native Americans sold the island of Manhattan 400 years ago for $24. If they had access to a financial investment that yielded an interest rate of 7% per year, how much would they have today? (8 points) a. (1.07)^400 x 24= $13.6 Trillion
4. For each of the following kinds of insurance, give an example of a behavior that can be called moral hazard and another example of behavior that can be called adverse selection: a. Medical insurance (6 points)
i. A sick person is more likely to apply to medical insurance compared to a healthy person. Meaning it’s an adverse selection. A healthy person may get health insurance too but now he may less likely to take care of himself, this would be a moral hazard. b. Car insurance (6 points)
i. A risky driver is more likely to apply for car insurance, this would be an adverse selection. Or once a driver has insurance, they may be driving more reckless, this would be a moral hazrd.
5. For each of the following pairs of bonds, which bond would you expect to pay a higher interest rate? Explain. (5 points each) a. A bond of the US government or a bond of an Eastern European government i. Eastern European because non-US bonds will include risk premiums and also have higher interest rates b. A bond that repays the principal in 2015 or a bond that repays the principal in 2040 i. 2040 because higher maturity requires higher interest rate. c. A bond from Coca-Cola or a bond from a software company that run in your garage i. The software company due to not being well known so it would be a higher interest rate. d. A bond issued by the federal government or a bond issued by the state of New York i. Definitely federal government because they are not tax-exempted compared to municipal bonds
6. When company executives buy and sell stock based on private information they obtain as part of their jobs, they are engaged in insider trading. a. Give an example of inside information that might be useful for buying or selling stock. (6 points) i. Information on new products or any government involvement that may affect the firm b. Those who trade stocks based on inside information usually earn very high rates of return.
Does this fact violate the efficient markets hypothesis? (6 points) i. Who does trade with inside information is not violating the efficient market hypothesis. The hypothesis includes all available information about the future of the firm. Inside information is not available to the public meaning the price of the stock doesn’t reflect this. c. Insider trading is illegal. Why do you suppose that is? (5 points) i. It’s illegal for sure due to the fact that it gives others an unfair advantage over everyone else who doesn’t have access to this.
7. Jamal has a utility function , where W is his wealth in millions of dollars and U is the utility that he obtains. a. Graph Jamal’s utility function. Is he risk averse? Explain. (7 points) i.
1. He is risk averse because of his chances of getting more money for more risk. b. In the final stage of a game show, the host offers Jamal a choice between: i. $4 million for sure
ii. A gamble that pays $1 million with 60% probability and $9 million with 40% probability Should Jamal pick choice i or choice ii? Hint: evaluate the utility that Jamal would expect to receive in choice i and choice ii. Jamal would expect to receive utility in the amount of the weighted average of the possible outcomes, where the probabilities are the weights. (7 points)
E(Utility) = 0.6*U(1000000) + 0.4*U(9000000) = 0.6*0 + 0.4*1 = 0.4
Jamel should pick option one because he has a only 40% in order to get the 9 million but it might not worth it because he could end up back at 1 million.
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