Solution Manual for Introduction to Finance Markets

Investments and Financial Management 14th Edition

by Melicher

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Solution Manual for Introduction to Finance Markets Investments and Financial Management

Chapter Seven: Savings and Investment Process

Chapter 7
Savings and Investment Process

CHAPTER PREVIEW

An effective financial system provides the funds needed for an economy to grow in terms of
gross domestic product by channeling savings into investment. The savings-investment
process in the U.S. financial system begins by first generating savings. These savings may
be directly invested by savers, or be accumulated by financial intermediaries which, in turn,
lend and invest the savings. After describing the composition of gross domestic product
(GDP), we discuss the expenditures and receipts of the federal government. We next cover
the historical role and creation of savings in the U.S. Then our attention turns to coverage of
the major sources of savings and the factors that affect savings. The last two sections in the
chapter cover first capital market securities and then provide a further look at the 2007-09
financial crisis.
Instructors will find a vast amount of information on aggregate savings, investment, and
government receipts and expenditures in newspapers, periodicals, and the reports of banks
and other financial institutions. The Economic Report of the President, issued early each
year, is an especially good source of statistical tables and charts as well as general
information.

LEARNING OBJECTIVES

• Identify and briefly describe the major components of the gross domestic product.
• Describe how the balance between exports and imports affects the gross domestic
product.
• Describe recent developments in the aggregate level of personal and corporate savings.
• Describe the principal sources of federal government revenues and expenditures.
• Discuss the historical role of savings in the United States and how savings are created.
• Identify the major sources of savings in the United States.
• Identify and describe the factors that affect savings.
• Describe major capital market securities that facilitate the savings and investment
process.
• Discuss the role of individuals in the recent financial crisis.

CHAPTER OUTLINE

I. GROSS DOMESTIC PRODUCT AND CAPITAL FORMATION

A. GDP Components
B. Implications of International Payment Imbalances
C. Link between Saving and Investment
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 Chapter Seven: Savings and Investment Process

II. FEDERAL GOVERNMENT RECEIPTS AND EXPENDITURES

A. The Budget
B. Fiscal Policy Makers
C. Debt Financing

III. HISTORICAL ROLE OF SAVINGS IN THE UNITED STATES

A. Foreign Sources of Savings
B. Domestic Supply of Savings
C. Creation of Savings

IV. MAJOR SOURCES OF SAVINGS

A. Personal Savings
B. Corporate Savings

V. FACTORS AFFECTING SAVINGS

A. Levels of Income
B. Economic Expectations
C. Economic Cycles
D. Life Stages of the Individual Saver
E. Life Stages of the Corporation

VI. CAPITAL MARKET SECURITIES

VII. A FURTHER LOOK AT THE 2007-09 FINANCIAL CRISIS

A. Early Factors
B. A Borrowing-Related Cultural Shift

VIII. SUMMARY

LECTURE NOTES

I. GROSS DOMESTIC PRODUCT AND CAPITAL FORMATION

All of a nation’s output of goods and services may be consumed, or a portion of them
may be saved. Savings can be invested to construct residential and nonresidential
structures, manufacture producers’ durable equipment, and increase business
inventories. This process is capital formation and results in economic growth.
Gross domestic product (GDP) is a nation’s output of goods and services for a
specified period of time. GDP is comprised of personal consumption expenditures
(PCE), government purchases of goods and services (GP), gross private domestic
investment (GPDI), and net exports of goods and services (NE). In equation form, we
have: GDP = PCE + GP + GPDI + NE.
(Use Tables 7.1 and 7.2 and Discussion Questions 1, 2, and 3 here.)

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II. FEDERAL GOVERNMENT RECEIPTS AND EXPENDITURES

The magnitude of the expenditures of federal government and the revenues required to
support such expenditures require much examination when considering any aspect of
the nation’s economy. Expenditures touch all of us—businesses as well as individuals,
as do the various taxes. Although we ordinarily think only of income or corporate
taxes, large sums are raised by the federal government from fees of various types:
excise taxes, postal receipts, rental receipts from federal housing projects, and a host
of other sources. In contrast with the early history of the nation, the federal
government now enters virtually all phases of our economic lives.
Figure 7.1 should stimulate class discussion. As shown in Figure 7.1 for fiscal
year 2008, the principal sources of federal revenues are: personal income taxes
(39%), social security and other retirement taxes (30%) borrowing to cover deficit
(15%), corporate income taxes (10%), and excise, estate, and other taxes (6%).
As shown in Figure 7.1 for fiscal 2008, the major expense items in the federal
budget are: social security, medicare, and other retirement (37%), national defense,
veterans, and foreign affairs (24%), social programs (including Medicaid) (20%),
physical, human and community development (9%), net interest on debt (8%), and law
enforcement and general government (2%).

Beginning in 1970 and continuing until fiscal 1998, the federal government
operated with an annual budget deficit. Surplus budgets were achieved during the next
four years (fiscal 1998 through fiscal 2001). Beginning in 2002 budget deficits
returned with the deficits becoming increasingly larger in recent years. Forecasts were
for a $1.4 trillion deficit in fiscal 2009 and a $1.6 trillion deficit in fiscal 2010.

(Use Figure 7.1and Discussion Questions 4, 5, and 6 here.)

III. HISTORICAL ROLE AND CREATION OF SAVINGS

Foreign capital played an important role in the economic development of the United
States, for example, in the early transportation system. After the Civil War, the
populace in the U.S. began to take over the function of providing savings for the
capital formation process. Today, the World Bank supplies large amounts of capital to
developing nations for purposes of increasing their productive capacity.
Savings are income that is not consumed but held in the form of cash and other
financial assets. Savings surplus occurs when an economic unit has current savings
that exceed its direct investment in real assets. Savings deficit takes place when
investment in real assets exceeds current savings. For example, a savings deficit
occurs when business firms as a group are unable to meet their plant and equipment
expenditure needs out of earnings retained in their businesses. In recent years
individuals as a group have been a savings surplus unit. Corporations also have been
generally a savings surplus unit. However, governments (both federal and state and
local) have recently been savings deficit units.
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(Use Discussion Questions 7 and 8 here.)

IV. MAJOR SOURCES OF SAVINGS

Personal saving is the savings of individuals equal to personal income less personal
current taxes less personal outlays. Voluntary savings are financial assets set aside for
use in the future. Contractual savings are disciplined by previous commitments that
the saver has some incentive to honor (e.g., accumulation of reserves in insurance and
pension funds).
The savings rate is defined as personal savings divided by disposable personal
income. In 2000, the personal savings rate in the U.S. was only 1.0 percent. The
savings rate in 2005 was 1.4 percent. In contrast, the savings rate was 8.1 percent in
1970 and 9.2 percent in 1975. The savings rate for 2006 had increased to 2.4 percent
and reached 4.6 percent in 2009 as indicated in Table 7.3.

Savings are the financial assets retained by the corporation out of funds generated
through business operations that are neither paid out in dividends nor invested in
operating assets of the business. Funds generated through business operations include
not only corporate earnings but also the conversion of operating assets to financial
assets through depreciation allowances. Corporations have short-term saving for
working capital purposes and long-term saving to meet future expenditures for
equipment, major maintenance, and the like. See Table 7.4 for nonfinancial corporate
savings in 2003, 2006, and 2008.

(Use Tables 7.3 and 7.4, and Discussion Questions 9 through 12 here.)

V. FACTORS AFFECTING SAVINGS

Savings are defined as current income less tax payments and consumption
expenditures. Factors that influence the total amount of savings in any given time
period include:
1. Levels of income
2. Economic expectations
3. Economic cycles
4. Life stages of the individual saver
5. Life stages of the corporation
Changes in business activity influence employment levels which, in turn, are
closely associated with income levels. Cyclical movements in the economy affect both
the level of savings and the types of savings. The instructor can generally involve the
class in a lively discussion of the level of savings as they relate to the life stage of the
individual saver. This discussion can often be extended to how the life stage of
business firms, particularly corporations, impact on their level of savings.

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(Use Discussion Questions 13 through 18 here.)

VI. CAPITAL MARKET SECURITIES

The two types of financial markets are money markets and capital markets. Money
markets are markets where debt securities of one year or less are issued or traded.
Capital markets are markets where debt securities with maturities longer than one
year and corporate stocks are issued or traded.

Figure 7.2 lists five major capital market securities. They are:
Mortgage: loan backed by real property in the form of buildings and houses.
Treasury bond: long-term debt instrument issued by the U.S. federal government.
Municipal bond: long-term debt instrument issued by a state or local government.
Corporate bond: debt instrument issued by a corporation to raise long-term funds.
Common stock: security that indicates ownership interest in a corporation.

(Use Discussion Questions 19 and 20 here.)

VII. A FURTHER LOOK AT THE 2007-09 FINANCIAL CRISIS

The seeds of the 2007-09 financial crisis were sown in the 2001 recession. Stock
prices peaked in 2000 with the bursting of the internet “bubble. Monetary and fiscal
policy attempted to stimulate economic activity by creating an environment of low
interest rates and high liquidity.

Historically, U.S. consumers limited their use of debt. However, by the first
decade of the twenty-first century, U.S. consumers wanted sooner, if not instant
gratification with respect to buying large-ticket items. The use of credit cards
increased dramatically and consumers borrowed heavily to purchase homes and other
expensive durable goods. The U.S. government encouraged the expansion of home
ownership to include individuals with relatively high credit risks. The bursting of the
“housing price” bubble in mid-2006, followed by the decline in economic activity that
resulted in a recession, caused many individuals not to be able to meet their mortgage
payments and other debt obligations.

(Use Discussion Question 21 here.)

DISCUSSION QUESTIONS AND ANSWERS

1. What is capital formation?

If all of a nation’s output of goods and services is not consumed, savings can be
invested to construct residential and nonresidential structures, manufacture producers’

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durable equipment, and increase business inventories. This process is capital formation
and results in economic growth.
2. Describe the major components of gross domestic product.
Gross domestic product (GDP) is comprised of: (a) personal consumption expenditures
(PCE) which are expenditures by individuals for durable goods, nondurable goods, and
services; (b) government purchases (GP) which are expenditures for goods and services
by both the federal and the state and local governments; (c) gross private domestic
investment (GPDI) which measures fixed investment in residential and nonresidential
structures, producers’ durable equipment, and changes in business inventories; and (d)
net exports (NE) of goods and services (i.e., exports minus imports). In equation form,
we have: GDP = PCE + GP + GPDI + NE. Also see Table 7.1.
3. Identify the major components of net savings and describe their relative contributions in
recent years.
The two major components of net savings are net private saving and net government
saving. Net private saving was in excess of $600 billion in 2003, 2006, and 2008.
Personal saving and undistributed corporate profits are the major contributors to net
private saving. Net government saving was negative in 2003, 2006, and 2008 with
dissaving approaching $700 billion in 2008 causing net saving to be -$23 billion. Net
government saving is comprised of federal and sate and local government savings. For
2008, the federal government saving was over -$600 billion and state and local saving was
-$40 billion. Table 7.2 provides details on net saving.
4. Identify the various sources of revenues of the federal government.
As shown in Figure 7.1 for fiscal year 2008, the principal sources of federal revenues
are: personal income taxes (39%), social security and other retirement taxes (30%)
borrowing to cover deficit (15%), corporate income taxes (10%), and excise, estate,
and other taxes (6%).
5. Identify the major expense categories in the federal budget.
As shown in Figure 7.1 for fiscal 2008, the major expense items in the federal budget
are: social security, medicare, and other retirement (37%), national defense, veterans,
and foreign affairs (24%), social programs (including Medicaid) (20%), physical,
human and community development (9%), net interest on debt (8%), and law
enforcement and general government (2%).
6. Describe whether the federal government has been operating with surplus or deficit
budgets in recent years.
Beginning in 1970 and continuing until fiscal 1998, the federal government operated
with an annual budget deficit. Surplus budgets were achieved during the next four years
(fiscal 1998 through fiscal 2001). Beginning in 2002 budget deficits returned with the
deficits becoming increasingly larger in recent years. Forecasts were for a $1.4 trillion
deficit in fiscal 2009 and a $1.6 trillion deficit in fiscal 2010.
7. Briefly describe the historical role of savings in the United States.
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In the earliest days of our economic development, most of the savings came from
foreign sources. After the Civil War, the United States gradually developed to the point
at which American families took over the function of providing savings for investment.
In recent years, savings have been high enough for large-scale investment in foreign
countries.
8. Compare savings surplus and savings deficit units. Indicate which economic units are
generally one type or the other.
Savings surplus exists when an economic unit has current savings that exceed its direct
investment in real assets. In contrast, a savings deficit unit is characterized by
expenditures in real assets that exceed current savings. As a result, savings surplus units
make their surplus savings available to savings deficit units. As noted in Table 7.2,
savings in recent years generally have come from individuals and business corporations.
The federal government has been a savings deficit unit in recent years. State and local
governments have been operating with deficit budgets in recent years.
9. Define personal saving.
Personal saving is the savings of individuals and equals personal income less personal
current taxes less personal outlays.
10. Also, differentiate between voluntary and contractual savings.
Voluntary savings are financial assets set aside for future use. Contractual savings are
disciplined by previous commitments and include such things as the accumulation of
reserves in insurance and pension funds.
11. Describe the recent levels of savings rates in the United States.
The savings rate is defined as personal savings divided by disposable personal income.
In 2000, the personal savings rate in the U.S. was only 1.0 percent. The savings rate in
2005 was 1.4 percent. In contrast, the savings rate was 8.1 percent in 1970 and 9.2
percent in 1975. The savings rate for 2006 had increased to 2.4 percent and reached 4.6
percent in 2009 as indicated in Table 7.3.
12. How and why do corporations save?
Savings are the financial assets retained by the corporation out of funds generated
through business operations that are neither paid out in dividends nor invested in
operating assets of the business. Funds generated through business operations include
not only corporate earnings but also the conversion of operating assets to financial
assets through depreciation allowances. Corporations have short-term saving for
working capital purposes and long-term saving to meet future expenditures for
equipment, major maintenance, and the like. See Table 7.4 for nonfinancial corporate
savings in 2003, 2006, and 2008.
13. Describe the principal factors that influence the level of savings by individuals.

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The principal factors that influence the levels of savings by individuals are: (a) levels of
income; (b) economic expectations; (c) economic cycles; and (d) the life stage of the
individual saver. A discussion of each of these is provided in the chapter.
14. How do economic cycle movements affect the media or types of savings by businesses?
Short-term or money market rates usually decrease during a period of economic
downturn, remain relatively low during the early stages of economic recovery, rise rapidly
with rapid economic growth, and peak when economic activity peaks. Financial
intermediation takes place as long as the interest rates on time and savings deposits exceed
other money market rates. Disintermediation occurs when the reverse interest rate
relationship exists. The elimination of interest rate ceilings on time and savings deposits
has resulted in a lessening of cyclical swings between intermediation and
disintermediation.
15. What are the life cycle stages of individuals?
The life cycle stages of individuals are: (a) formative/education developing, (b) career
starting/family creating, (c) wealth building, and (d) retirement enjoyment.
16. How does each stage relate to the amount and type of individual savings?
During the first stage there typically is no savings but rather a consumption of their
parents’ savings. During the second stage, there is little savings but an earning power
potential has been established. Most savings occur during the third stage, while the fourth
stage often involves dissaving.
17. What are the life cycle stages of corporations and other business firms?
The life cycle stages of a successful business firm are: (a) start-up stage, (b) survival
stage, (c) rapid growth stage, and (d) maturity stage.
18. Explain how financial savings generated by a business are a function of its life cycle?
During the and early stages and at least during the early part of the rapid growth stage
of a successful business, the need to replace and add physical or real assets causes the
firm to dissave; that is, the firm usually relies heavily on borrowed capital. However,
as the firm becomes more mature, expansion begins to slow and this, along with a
continuing large flow of cash, results in financial savings.

19. What are the two types of financial markets?

The two types of financial markets are money markets and capital markets. Money
markets are markets where debt securities of one year or less are issued or traded.
Capital markets are markets where debt securities with maturities longer than one
year and corporate stocks are issued or traded.

20. Identify and briefly describe the major securities that are originated or traded in
capital securities markets.

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Figure 7.2 lists the following five major capital market securities:
Mortgage: loan backed by real property in the form of buildings and houses.
Treasury bond: long-term debt instrument issued by the U.S. federal government.
Municipal bond: long-term debt instrument issued by a state or local government.
Corporate bond: debt instrument issued by a corporation to raise long-term funds.
Common stock: security that indicates ownership interest in a corporation.

21. What role did individuals play in the development of the 2007-09 financial crisis?

Historically, U.S. consumers limited their use of debt. However, by the first decade of
the twenty-first century, U.S. consumers wanted sooner, if not instant gratification
with respect to buying large-ticket items. The use of credit cards increased
dramatically and consumers borrowed heavily to purchase homes and other expensive
durable goods. The U.S. government encouraged the expansion of home ownership to
include individuals with relatively high credit risks. The bursting of the “housing
price” bubble in mid-2006, followed by the decline in economic activity that resulted
in a recession, caused many individuals not to be able to meet their mortgage
payments and other debt obligations.

EXERCISES AND ANSWERS

1. Go to the U.S. Department of Commerce, Bureau of Economic Analysis website at

http://www.bea.gov and determine:

a. The current personal savings rate in the United States.

The instructor will need to access the Department of Commerce web site to
supplement the current personal savings rates indicated in the chapter.

b. The amount of current corporate savings as reflected in the amount of undistributed

profits.

The instructor will need to access the web site for the Department of Commerce to
supplement the corporate savings data presented in the chapter.

2. Assume you are an elected member of Congress. A lobbying group has agreed to provide
financial support for your reelection campaign next year. In return for the group’s
support, you have been asked to champion their self-interests in the form of a spending
bill that is being considered by Congress. What would you do?

Ethical behavior is how an individual or organization treats other legally, fairly, and
honestly. As an elected member of Congress you have a responsibility to all of your
constituencies. Most individuals who seek election to Congress will need financial
support of a variety of backers. However, it would be unethical to “blindly” support the
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self-interests of one group at the expense of other constituencies. It would be prudent

to independently assess the merits of the spending bill being considered by Congress
and its likely impact on all of your constituents so that you can make a well-informed,
independent judgment.

3. Match the following financial instruments and securities with their issuers.

Instruments/Securities Issuers
a. corporate stocks [#2] 1. commercial banks
b. Treasury bonds [#3] 2. corporations
c. municipal bonds [#4] 3. U.S. government
d. negotiable certificates of deposit [#1] 4. state/local governments

4. Match the following financial instruments and securities with their typical maturities.

Instruments/Securities Maturities
a. corporate stocks [#2] 1. less than one year
b. Treasury bills [#4] 2. no maturity
c. mortgages [#3] 3. up to about 30 years
d. commercial paper [#1] 4. up to one year

[Note: There are only four exercise assignments. Exercise 5 indicted in the text should
have been numbered exercise 4.]

PROBLEMS AND ANSWERS

1. A very small country’s gross domestic product is $12 million.

a. If government expenditures amounted to $7.5 million and gross private domestic

investment is $5.5 million, what would be the amount of net exports of goods and
services?

GDP = PCE + GE + GPDI + NE

Where GDP = gross domestic product; PCE = personal consumption expenditures,
GE = government expenditures, GPDI = gross private domestic investment, and NE
= net exports of goods and services.

The NE cannot be determined unless we know PCE.

NE = $12 million - ?$PCE - $7.5 million - $5.5 million
For example, if personal consumption expenditures = $0.0 million, then:
NE = $12 million - $0.0 - $7.5 million - $5.5 million = -$1 million
A positive amount of PCE would result in the NE being an even larger deficit
number.
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2. How would your answer change in Problem 1 if the gross domestic product had been
$14 million?

See comments for Problem 1.

NE = $14 million - ?$PCE - $7.5 million - $5.5 million
PCE could be $1 million before NE would turn negative.

3. Personal income amounted to $17 million last year. Personal current taxes amounted to
$4 million and personal outlays for consumption expenditures, non-mortgage interest,
and so forth were $12 million.

a. What was the amount of disposable personal income last year?

Disposable personal income (DPI) = personal income – personal current taxes

DPI = $17 million - $4 million = $13 million

b. What was the amount of personal saving last year?

Personal savings (PS) = disposable personal income – personal outlays

PS = $13 million - $12 million = $1 million

c. Calculate personal saving as a percentage of disposable personal income.

Savings rate = $1 million/$13 million = 7.7%

4. Assume personal income was $28 million last year. Personal outlays were $20 million
and personal current taxes were $5 million.

a. What was the amount of disposable personal income last year?

Disposable personal income (DPI) = personal income – personal current taxes

DPI = $28 million - $5 million = $23 million

b. What was the amount of personal saving last year?

Personal savings (PS) = disposable personal income – personal outlays

PS = $23 million - $20 million = $3 million

c. Calculate personal saving as a percentage of disposable personal income.

Savings rate = $3 million/$23 million = 13.0%

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5. The components that comprise a nation’s gross domestic product were identified and
discussed in the chapter. Assume the following accounts and amounts were reported by a
nation last year. Government purchases of goods and services were $5.5 billion; personal
consumption expenditures were $40.5 billion; gross private domestic investment
amounted to $20 billion; capital consumption allowances were $4 billion; personal
savings were estimated at $2 billion; imports of goods and services amounted to $6.5
billion; and the exports of goods and services were $5 billion.
a. Determine the nation’s gross domestic product.
See combined GDP solutions for (a) and (b) under (b).
b. How would your answer change if the dollar amounts of imports and exports are
reversed?
Part A Part B
Personal consumption expenditures (PCE) $40.5 billion $40.5 billion
Gross private domestic investment (GPDI) 20.0 billion 20.0 billion
Government purchases of goods & services (GP) 5.5 billion 5.5 billion
Net exports (NE)[calculated as exports – imports] –1.5 billion 1.5 billion
Gross domestic product (GDP) $64.5 billion $67.5 billion
6. Assume some of the data provided in Problem 1 [note: the correct reference should be to
Problem 5] changes next year. Specifically, government purchases of goods and
services increase by 10 percent; gross private domestic investment declines by 10
percent; and the imports of goods and services drop to $6 billion. Assume the other
information as given remains the same next year.
a. Determine the nation’s gross domestic product for next year.

Personal consumption expenditures (PCE) $40.50 billion

Gross private domestic investment (GPDI) 18.00 billion
Government purchases of goods & services (GP) 6.05 billion
Net exports (NE) [exports – imports] -1.00 billion
Gross domestic product (GDP) $63.55 billion

b. How would your answer change in (a) if personal consumption expenditures are only
$35 billion next year and capital consumption allowances actually increase by
10 percent?

Personal consumption expenditures (PCE) $35.00 billion

Gross private domestic investment (GPDI) 18.00 billion
Government purchases of goods & services (GP) 6.05 billion
Net exports (NE) [exports – imports] -1.00 billion
Gross domestic product (GDP) $58.05 billion

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7. A nation’s gross domestic product is $600 million. Its personal consumption expenditures
are $350 million and government purchases of goods and services are $100 million. Net
exports of goods and services amount to $50 million.
a. Determine the nation’s gross private domestic investment.
See combined GPDI solutions for (a) and (b) under (b).
b. If imports exceed exports by $25 million, how would your answer to (a) change?
GDP = PCE + GPDI + GP + NE
GPDI = GPD – PCE – GP – NE
Part A Part B
GPD $600 million $600 million
Less PCE –350 million –350 million
Less GP –100 million –100 million
Less NE –50 million +25 million
GPDI $100 million $175 million
8. A nation’s gross domestic product is stated in U.S. dollars at $40 million. The dollar
value of one unit of the nation’s currency (FC) is $0.25.
a. Determine the value of GDP in FC’s.
$40 million × $.25 = 10 million FCs
b. How would your answer in (a) change if the dollar value of one FC increases to
$0.30?
$40 million × $.30 = 12 million FCs
9. A country in Southeast Asia states its gross domestic product in terms of yen. Last year
its GDP was 50 billion yen when one U.S. dollar could be exchanged into 120 yen.
a. Determine the country’s GDP in terms of U.S. dollars for last year.
(50 billion yen)/120 yen = $416.7 million
b. Assume the GDP increases to 55 billion yen for this year. However, the dollar value
of one yen is now $0.01. Determine the country’s GDP in terms of U.S. dollars for
this year.
(55 billion yen) × $.01 = $550 million
c. Show how your answer in (b) would change if one U.S. dollar could be exchanged
for 110 yen.
(55 billion yen)/110 yen = $500 million

10. Challenge Problem (Note: This exercise requires knowledge of probabilities and
expected values.) Following are data relating to a nation’s operations last year.

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Capital consumption allowances $150 million

Undistributed corporate profits 40 million
Personal consumption expenditures 450 million
Personal savings 50 million
Corporate inventory valuation adjustment -5 million
Federal government deficit -30 million
Government purchases of goods and services 10 million
State and local governments surplus 1 million
Net exports of goods and services -2 million
Gross private domestic investment 200 million

a. Determine the nation’s gross domestic product (GDP).

Personal consumption expenditures (PCE) $450 million

Gross private domestic investment (GPDI) 200 million
Government purchases of goods & services (GP) 10 million
Net exports (NE) [exports – imports] -2 million
Gross domestic product (GDP) $658 million

b. How would your answer change in (a) if exports of goods and services were $5
million and imports were 80 percent of exports?

Personal consumption expenditures (PCE) $450 million

Gross private domestic investment (GPDI) 200 million
Government purchases of goods & services (GP) 10 million
Net exports (NE) [exports – imports] -1 million
Gross domestic product (GDP) $659 million

c. Show how the GDP in (a) would change under the following three scenarios:
Scenario 1 (probability of .20) that the GDP components would be 120 percent of
their values in (a); Scenario 2 (probability of .50) that the GDP component values
used in (a) would occur; and Scenario 3 (probability of .30) that the GDP
components would be 75 percent of their values in (a). [note: this exercise requires
a knowledge of probabilities and expected values.]

PCE: (1) $450 million x 1.20 = $540 million; (2) $450 million x 1.00 = $450
million; and (3) $450 million x .75 = $337.50 million
GPDI: (1) $200 million x 1.20 = $240 million; (2) $200 million x 1.00 = $200
million; and (3) $200 .75 = $150 million
GP: (1) $10 million x 1.20 = $12 million; (2) $10 million x 1.00 = $10 million; and
(3) $10 million x .75 = $7.5 million
NE: (1) $-2 million x 1.20 = $-2.4 million; (2) $-2 million x 1.00 = $-2 million; and
(3) $-2 million x .75 = $-1.5 million
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PCE Expected value (in $ millions): $540(.20) + $450(.50) + $337.50(.30) = $108 +

$225 + 101.25 = $434.25 million
GPDI Expected value (in $ millions): $240(.20) + $200(.50) + $150(.30) = $48 +
$100 + 45 = $193
GP Expected value (in $ millions): $12(.20) + $10(.50) + $7.5(.30) = $2.4 + $5 +
$2.25 = $9.65
NE Expected value (in $ millions): $-2.4(.20) + $-2(.50) + $-1.5(.30) = $-.48 + $-1
+ $-.45 = $-1.93

GDP Expected value (in $ millions): $434.25 + $193 +$9.65 + ($-1.93) = $634.97
Check: $658(1.20)(.20) + $658(1.00)(.50) + $658(.75)(.30) = $157.92 + $329.00 +
$148.05 = $634.97

d. Determine the nation’s gross savings last year.

Personal savings $50 million

Undistributed corporate profits 40 million
Corporate inventory valuation adjustment -5 million
Capital consumption allowances 150 million
Federal government deficit -30 million
State and local government surplus 1 million
Gross savings $206 million

e. Show how your answer in (d) would change if each account simultaneously
increases by 10 percent.

Gross savings: $206 million x 1.10 = $226.6 million

f. Show how your answer in (d) would change if each account simultaneously
decreases by 10 percent.

Gross savings: $206 million x .90 = $185.40

g. Show how your answer in (d) would have changed if Capital consumption
allowances had been 10 percent less and personal consumption expenditures had
been $400 million.

Capital consumption allowances: $150 million x .90 = $135 million

Personal savings $50 million

Undistributed corporate profits 40 million
Corporate inventory valuation adjustment -5 million
Capital consumption allowances 135 million
Federal government deficit -30 million
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Solution Manual for Introduction to Finance Markets Investments and Financial Management

Chapter Seven: Savings and Investment Process

State and local government surplus 1 million

Gross savings $191 million

SUGGESTED QUIZ

1. Define or discuss briefly:

a. Capital formation
b. Contractual savings
c. Savings surplus units
d. Capital market securities

2. Identify and describe briefly the major components of gross domestic product.

3. Comment on the general relationship between federal government receipts and

expenditures in recent years.

4. Identify and discuss briefly the major factors that affect savings.

5. List the major capital market securities described in the chapter.

7-16

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