Macro Tut 4 - Saving, Investment and the Financial System

Multiple Choice: Identify the choice that best completes the statement or answers the question.

1. At the broadest level, the financial system moves the economy’s scarce resources from
a. the rich to the poor.
b. financial institutions to business firms and government.
c. households to financial institutions.
d. savers to borrowers.
At the broadest level, the financial system moves the economy’s scarce resources from savers (people who spend
less than they earn) to borrowers (people who spend more than they earn)

2. A perpetuity is distinguished from other bonds in that it

a. pays continuously compounded interest.
b. pays interest only when it matures.
c. never matures.
d. will be used to purchase another bond when it matures unless the owner specifies
otherwise.
A perpetual bond is a bond with no maturity date that theoretically pays interest forever. Perpetual bonds work
like regular bonds in that they pay regular fixed-interest payments. Most perpetual bonds are callable, which
means the issuer can redeem them after a specified time frame.

3. The prices of stock traded on exchanges are determined by

a. the Corporate Stock Administration.
b. the administrators of NASDAQ.
c. the supply of, and demand for, the stock.
d. All of the above are correct.
Determinants for stock price are almost the same for other assets, which explain its drive being the supply and
demand for the stock.
The initial price of one stock is decided at the Initial Public Offering (IPO), which is determined by the volume of
capital and number of stocks made available on the stock exchange.

4. A high demand for a company’s stock is an indication that

a. the company is in need of funds.
b. the company has recently sold a large quantity of bonds.
c. people are optimistic about the company’s future.
d. people are pessimistic about the company’s future.
Also, higher demand in a period will result in higher price of the stock.
The opposite effect will apply to the stock price if they have lower demand.

5. Which of the following statements is correct?

a. Stocks, bonds, and deposits are all similar in that each provides a common
medium of exchange.
b. Most buyers of stocks and bonds prefer those issued by large and familiar
 companies.
c. Banks charge borrowers a slightly lower interest rate than they pay to depositors.
d. None of the above is correct.
This is also common sense. For example, people would want to acquire the stock of Techcombank more than they
would want with stock of a smaller bank like SCB or OCB.
A. Stocks, bonds, and deposits not common medium of exchange. They represent a method of investment
C. Banks have to charge borrowers higher than depositors in order to create revenue
6. Which of the following are financial intermediaries?
a. both banks and mutual funds
b. banks but not mutual funds
c. mutual funds but not banks
d. neither banks or mutual funds

7. Which of the following equations will always represent GDP in an open economy?
a. S = I - G
b. I = Y - C + G
c. Y = C + I + G
d. Y = C + I + G + NX
This is applied to an open economy, where import and export exist.
In a closed economy, it could be Y = C + I + G

8. In a closed economy, national saving is

a. usually greater than investment.
b. equal to investment.
c. usually less than investment because of the leakage of taxes.
d. always less than investment.
In a closed economy, national savings is the sum of private saving and the public saving.
In an open economy, national saving is the sum of private savings, the public saving, and net capital inflows.

9. The country of Hykenia does not trade with any other country. Its GDP is $20 billion. Its government
collects $4 billion in taxes and pays out $3 billion to households in the form of transfer payments.
Consumption equals $15 billion and investment equals $2 billion. What is public saving in Hykenia, and
what is the value of the goods and services purchased by the government of Hykenia?
a. -$2 billion and $3 billion
b. $1 billion and $3 billion
c. -$1 billion and $4 billion
d. There is not enough information to answer the question.
Y = C + I + G => G = Y – C – I = 20 – 15 – 2 = 3
Public saving = T – G - TR = 4 – 3 – 3 = -2
10. In a closed economy, public saving is the
a. amount of income that households have left after paying for taxes and consumption.
b. amount of income that businesses have left after paying for the factors of production.
c. amount of tax revenue that the government has left after paying for its spending.
d. sum of A, B, and C.
Public saving = T (tax) – G (government spending) – TR (government transfer payment)

11. A budget surplus is created if

a. the government sells more bonds than it buys back.
b. the government spends more than it receives in tax revenue.
c. private saving is greater than zero.
d. None of the above is correct.
A budget surplus occurs when income exceeds expenditures
It should be the opposite of statement B

12. The slope of the demand for loanable funds curve represents the
a. positive relation between the real interest rate and investment.
b. negative relation between the real interest rate and investment.
c. positive relation between the real interest rate and saving.
d. negative relation between the real interest rate and saving.

13. In the loanable funds model, an increase in an investment tax credit would create a
a. shortage at the former equilibrium interest rate. This shortage would lead to a rise in the
interest rate.
b. shortage at the former equilibrium interest rate. This shortage would lead to a
fall in the interest rate.
c. surplus at the former equilibrium interest rate. This surplus would lead to a rise
in the interest rate.
d. surplus at the former equilibrium interest rate. This surplus would lead to a fall
in the interest rate.
Investment tax credits are federal tax incentive for business investment. They let individuals or businesses deduct
a certain percentage of investment costs from their taxes.
An investment tax credit will shift the demand for loanable funds to the right, resulting in a shortage of supply (at
the former equilibrium interest rate) and a rise in interest rate.
14. An increase in the budget deficit (G-T)
a. makes investment spending fall.
b. makes investment spending rise.
c. does not affect investment spending.
d. may increase, decrease, or not affect investment spending.
Budget deficit + => Tax - => Lower public saving/supply for funds => investment spending fall
(supply curve shifted to the left)
The crowding out effect occurs when a government runs a budget deficit and, as a result, causes a decrease in
general investment (due to lower supply for loanable funds). When the government borrows money, this results in
an increase in the demand for loanable funds, as shown on the right.
This could also be explained for question 12. Due to its nature, Investment tax credits reduce the actual tax
collected by the government (reducing private investment and increasing demand for loanable funds), and
therefore create a budget deficit.

15. Bolivia had a smaller budget deficit in 2003 than in 2002. Other things the same, we would expect this
reduction in the budget deficit to have
a. increased both interest rates and investment.
b. increased interest rates and decreased investment.
c. decreased interest rates and increased investment.
d. decreased both interest rates and investment.
Budget surplus/lower deficit decrease the demand for loanable funds (investment) OR increase the supply of
loanable funds (savings)
Lower budget deficit is a result of government trying to reach budget surplus, by increasing tax rate, which would
result in lower investment and increase in savings (supply of loanable funds)

16. If the government instituted an investment tax credit, then which of the following would be higher in
equilibrium?
a. saving and the interest rate
b. saving but not the interest rate
c. the interest rate but not saving
d. neither saving nor the interest rate
 Figure 26-1. The figure depicts a demand-for-loanable-funds curve and two supply-of-loanable-funds
curves.

S1 S2

Demand

17. Refer to Figure 26-1. Which of the following events would shift the supply curve from S1 to S2?
a. In response to tax reform, firms are encouraged to invest more than they previously
invested.
b. In response to tax reform, households are encouraged to save more than they
previously saved.
c. Government goes from running a balanced budget to running a budget deficit.
d. Any of the above events would shift the supply curve from S1 to S2.

ANS:
1D 2C 3C 4C 5B 6A 7D 8B 9A 10C 11D 12B 13A 14A 15C 16A 17B

EXERCISES AND PROBLEMS

Exercise 1: Fill the blank with NO MORE THAN 4 WORDS:

1. The budget balance is the difference between …………….. and government spending.
2. …………………………, the sum of private savings and the budget balance, is the total amount of
savings generated within the economy.
3. The loanable funds market is a hypothetical market that examines the …………………… of the
demand for funds generated by borrowers and the supply of funds provided by lenders.
4. ……………………. is the price, calculated as a percentage of the amount borrowed, charged by the
lender to a borrower for the use of their savings for one year.
5. Crowding out is the …………… effect of budget deficits on private investment.
6. A household’s wealth is the value of its………………………...
7. The ………………………….. shows how loans from savers are allocated among borrowers with
investment spending projects.
8. According to the savings–investment spending identity, savings and investment spending are always
…………. for the economy as a whole.
 9. …………. is a financial intermediary that provides liquid assets in the form of bank deposits to
lenders and uses those funds to finance the illiquid investments or investment spending needs of
borrowers.

Exercise 2: Find the underlined parts that are incorrect in these statements and correct them:

10. Investors typically wish to reduce their risk by engaging in diversification, owning a narrow
A B C

range of assets whose returns are based on unrelated, or independent, events.

D
11. The budget deficit is the difference between tax revenue and government spending when

A B C
tax revenue exceeds government spending.
D
12. A liability is an option to pay income in the future.
A B C D
13. A loan is a lending agreement between government and a particular borrower.
A B C D
14. Shareowners are able to enjoy the lower returns over time that stocks generally offer in

A B C
comparison to bonds.
D
ANS:
1. tax revenue
2. National savings
3. market outcome
4. The interest rate
5. negative
6. accumulated savings
7. hypothetical loanable funds market
8. equal
9. A bank
10. C -> wide
11. A -> surplus
12. B -> a requirement
13. C -> a particular lender
14. B -> higher

Problem 1:
Identify each of the following acts as representing either saving or investment.
a. Lan uses some of his income to buy government bonds.
b. Minh takes some of his income and buys mutual funds.
c. Linh purchases a new truck for his delivery business using borrowed funds.
d. Peter uses some of his income to buy stock in a major corporation,
e. Dave hires a builder to construct a new home using borrowed funds.

a. Lan is saving.
 b. Minh is saving.
c. Linh is investing.
d. Peter is saving.
e. Dave is investing.

Problem 2:
Suppose GDP equals $10 trillion, consumption equals $6.5 trillion, the government spends $2 trillion and has a budget
deficit of $300 billion.
a. Find public saving, taxes, private saving, national saving, and investment.
b. Suppose now that the government cuts taxes by $200 billion. In each of the following two scenarios, determine what
happens to public saving, private saving, national saving, and investment.
1. Consumers save the full proceeds of the tax cut.
2. Consumers save 1/4 of the tax cut and spend the other 3/4

Given: Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3

Public saving = T – G = – 0.3
Taxes: T = G – 0.3 = 1.7
Private saving = Y – T – C = 10 – 1.7 – 6.5 = 1.8
National saving = Y – C – G = 10 – 6.5 = 2 = 1.5 => Investment = national saving = 1.5
In both scenarios, public saving falls by $200 billion, and the budget deficit rises from $300 billion to $500 billion. 1.
If consumers save the full $200 billion, national saving is unchanged, so investment is unchanged. 2. If consumers
save $50 billion and spend $150 billion, then national saving and investment each fall by $150 billion.
Problem 3:
Graphically show the impact on the loanable fund in each of the following scenario
a. The economy is in a recession and businesses begin to expect it will continue indefinitely.

b. Technological advancements increase productivity for firms who make new investments.

c. The Government increases taxes by $100 million and decreases spending by $100 million
Public saving = T – G = + 200 million
d. Hyperinflation increase the incentive for consumers to spend
Private saving decreases => National saving decreases

e. There is a significant increase in business confidence

f. The government increases spending by $1 trillion to fund infrastructure projects like roads, bridges and upgrades to
the electrical grid.
Short-term: G increases => public savings => S shifts to the left
Long-term: business confidence increases => D shifts to the right