Unit 5.

Saving, investment, and the financial system

1. Answer:
a. Fred is saving.
b. Julie is saving.
c. Alex is investing.
d. Elaine is saving.
e. Henrietta is investing.
2. Private saving is Y - C - T,
Public Saving is T – G
3. The difference between stocks and bonds is that stocks are shares in the ownership of a business,
while bonds are a form of debt that the issuing entity promises to repay at some point in the future.
A balance between the two types of funding must be achieved to ensure a proper capital structure
for a business.
4. The earnings per share is ($45 million - $15 million)/10 million = $3.
So, the price- earnings ratio is $90/$3 = 30.
This is a high P/E ratio, as the historical average for the market is about 15. The high PE ratio may
indicate people expect the firm to have higher earnings in the future or that the stock has become
overvalued.
5. The supply for loanable funds (SLF) curve slopes upward because the higher the real interest
rate, the higher the return someone gets from loaning his or her money. The demand for loanable
funds (DLF) curve slopes downward because the higher the real interest rate, the higher the price
someone has to pay for a loan.
6. As shown in the graph below, the economy starts in equilibrium at point E0 with interest rate r0
and equilibrium quantity of saving and investment at q0. If the government succeeds in obtaining a
surplus, there will be more public saving in the economy and so more national saving at each
interest rate, and the supply of loanable funds curve will shift from S0 to S1. The new equilibrium
will be at E1, with a lower interest rate, r1 and a higher quantity of saving and investment, q1.
Hence, if the federal government succeeds in having a surplus, interest rates will fall and
investment will increase. Market for Loanable Funds

7. The claim that an increase in the interest rate decreases investment supposes that only the
interest rate changes and everything else is constant. The investment tax credit causes investment
to rise at each interest rate. As firms want to borrow more the interest rate will rise. The rise in
interest rates does make investment less than it would otherwise be, but unless the supply of
loanable funds is vertical, the increase in investment demand from the tax credit is larger than the
decrease in investment demand from the rising interest rate.
8.
* Analysis and investors review a company's P/E ratio when they determine if the share price
accurately represents the projected earnings per share. The formula and calculation used for this
process follow.
P/E Ratio= Earnings per share/ Market value per share
or
P/E = Stock Price Per Share / Earnings Per Share
or
P/E = Market Capitalization / Total Net Earnings
or
Justified P/E = Dividend Payout Ratio / R – G
R = Required Rate of Return
G = Sustainable Growth Rate
* Companies with a high Price Earnings Ratio are often considered to be growth stocks. This
indicates a positive future performance, and investors have higher expectations for future earnings
growth and are willing to pay more for them. The downside to this is that growth stocks are often
higher in volatility and this puts a lot of pressure on companies to do more to justify their higher
valuation. For this reason, investing in growth stocks will more likely be seen as
a risky investment. Stocks with high P/E ratios can also be considered overvalued.