Issues in Economics Today 8th Edition Guell Solutions Manual

Issues in Economics Today 8th Edition
Guell Solutions Manual

Visit to download the full and correct content document: https://testbankdeal.com/dow
nload/issues-in-economics-today-8th-edition-guell-solutions-manual/
Chapter 7
Interest Rates and Present Value
Learning Objectives
After reading this chapter you should be able to:
LO1 Describe what interest rates are and differentiate nominal from real interest
rates.
LO2 Describe the use of present value calculations in determining the value of a
payment stream.
LO3 Apply the tool of present value when thinking about economic decisions
where the costs and benefits of the decisions happen at different times.
Chapter Outline
• Interest Rates
• Present Value
• Future Value
• Kick It Up a Notch: Risk and Reward
INTEREST RATES
Interest Rate
• The interest rate is the percentage, usually expressed in annual terms, of a
balance that is paid by a borrower to a lender that is in addition to the original
amount borrowed or lent.
The Market for Money

Teaching Tips
1) Suggest that the market for
money is like a moving van
rental market. The consumer
will return what was borrowed
and pay a price.
2) The interest rate is that price
the consumer pays for using the
money.
3) The lender is letting someone
use the money for a price.
Drawing Tip
Draw the axes putting the interest rate in
the price location and the money
borrowed/saved in the quantity location.
Page 1
© 2018 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in
any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Drawing Tip
Put in a demand curve.
Teaching Tip
Let students discuss why they think the
demand curve would be downward
sloping. Get them to see the interest rate
as the price of “renting money”.
Drawing Tip
Put in a supply curve.
Teaching Tip
Let students discuss why they think the
supply curve would be upward sloping.
Drawing Tip
Label the equilibrium interest rate and
amount borrowed.
Page 2
Nominal vs. Real Interest Rates
• Nominal Interest Rate: the advertised rate of interest
• Real Interest Rate: the rate of interest after accounting for inflation expectations
o It is also the compensation for waiting on consumption.
Teaching Tips
1) Do not try to deal with the interaction term. (In reality, nominal interest rates are the sum of
real interest rates and inflation expectations plus their product.)
2) Do some basic examples. (If inflation is expected to be 3% and nominal interest rates are 6%,
what is the real interest rate?)
3) Emphasize that real interest rates are what people get for waiting to use their money.
4) Emphasize that economists tend to focus more on real interest rates than nominal ones.
PRESENT VALUE
• Present Value is the interest adjusted value of future payment streams.
• Mathematically, the present value of a payment is
=(payment)/(1+r)n
Where
r is the interest rate.
n is the number of years until the payment is received/made.
Table 7.1
The amount payable for every dollar borrowed for
several interest rates and several loan durations.
Year/Interest rate 20% 10% 5% 2% 1%
30 237.38 17.45 4.32 1.81 1.35
10 6.19 2.59 1.63 1.22 1.10
5 2.49 1.61 1.28 1.10 1.05
1 1.20 1.10 1.05 1.02 1.01
Examples from This Table

• If you borrow $1 and promise to pay it back in 5 years at 5% interest you will owe
$1.28 which is the original $1 plus 28 cents in interest.
• If you borrow $1 and promise to pay it back in 30 years at it 20% interest you will
owe $237.38 which is the original $1 plus $236.38 in interest.
Teaching Tips
1) Get students to see the impact of high interest rate credit cards.
2) Let students discuss their credit card experiences.
Page 3
Mortgages, Car Payments, and Other Multiple Payment Examples
• Mortgages are loans taken out to buy homes. Typically, you borrow a large sum
of money and promise to pay it back in even amounts each month for 10, 15, or
30 years.
• Car loans are similar to mortgages in that you borrow a large sum but the loan
duration is usually two to six years.
Teaching Tip
Remind students that their student loans are multiple payment loans where they will pay off their
balances over time.
Table 7.3
Monthly payments required on a $1,000 loan
for various interest rates and various loan durations.
Years/Interest Rate 20% 10% 5% 2% 1%
30 16.71 8.78 5.37 3.70 3.22
10 19.33 13.22 10.61 9.20 8.76
5 26.49 21.25 18.87 17.53 17.09
1 92.63 87.92 85.61 84.24 83.79
Examples from This Table

• If you borrow $1,000 and promise to pay it back monthly over 5 years at 5%
interest you will owe $18.87 per month.
• If you borrow $1,000 and promise to pay it back monthly over 10 years at 20%
interest you will owe $19.33 per month.
Multi-Year Analysis
• Many investments garner upfront costs and yield later benefits.
• The wisdom of these investments depends on whether the present value of
benefits is greater than the present value of costs.
• The present value of the same cash flows depends greatly on the interest rate.
Teaching Tip
The point of the next three tables is to show the negative relationship between interest rates and PV.
Do not spend a great deal of time in the details. Just reinforce the following: investments that make
sense at low interest rates may not make sense at higher ones.
Page 4
Table 7.2
A multiple year example (5%).
Year Cost Benefit PV Cost @5% PV Benefit @5%
1 100 100.00
2 100 95.24
3 100 90.70
4 100 86.38
5 100 82.27
6 100 78.35
7 100 74.62
8 100 71.07
9 100 67.68
10 100 64.46
11 100 61.39
12 100 58.47
500 700 454.60 476.05
Page 5
Table 7.2
1 100 100.00
2 100 92.59
3 100 85.73
4 100 79.38
5 100 73.50
6 100 68.06
7 100 63.02
8 100 58.35
9 100 54.03
10 100 50.02
11 100 46.32
12 100 42.89
500 700 431.21 382.68
Page 6
Table 7.2
1 100 100.00
2 100 90.91
3 100 82.64
4 100 75.13
5 100 68.30
6 100 62.09
7 100 56.45
8 100 51.32
9 100 46.65
10 100 42.41
11 100 38.55
12 100 35.05
500 700 416.99 332.52
Internal Rate of Return

• Internal Rate of Return: the interest rate where the present value of costs and
benefits are equal
Teaching Tips
1) Refer back to the previous tables and note that the net present value is positive at 5% and
negative at 8%. Note that this means that the IRR is between 5% and 8%.
2) You can use the IRR function in Excel to show that it is 5.8245%.
FUTURE VALUE
• Future value is the interest-adjusted value of past payments.
= × (1 + )
Page 7
Rule of 72
• Rule of 72: a shortcut that allows you to estimate the time it would take for an
investment to double by dividing 72 by the annual interest rate
o For example: How long would it take to double your money ($10,000) at 4%
interest?
• FV formula: $10,000 x (1.04)^18 = $20,258.17 (so a little less than 18
years is the answer)
• Rule of 72: 72/4 = 18 years
KICK IT UP A NOTCH: RISK AND REWARD

• Risk: the possibility that the investor will not get those anticipated payoffs
o Default Risk: the risk to the investor that the borrower will not pay
o Market Risk: the risk that the market value of an asset will change in an
unanticipated manner
• Reward
o Risk Premium: the reward investors receive for taking greater risk
The Yield Curve

• Yield Curve: the relationship between reward and the time until the reward is
received
Figure 7.2
Yield curve for U.S. treasuries, January 2016, with maturities to 2046.
Page 8
End of Chapter Questions
Quiz Yourself
1. When evaluating a business decision, an economist will often resort to the use of
present value because
a) the profits may not be large enough to warrant the time and attention of the
investor.
b) the investment occurs in one time period and the profits in another.
c) the investment is often in one currency and the profits in another.
d) the investment is often under one set of managers and the profits under another.
Explanation: Present value is the interest-adjusted value of future payment streams. Two
amounts paid apart from one another in time are equal in present value if the money paid
now could be invested at an appropriate interest rate and generate an amount that turns
out to be equal to a higher amount that is paid later.
2. In the market for loanable dollars, an increase in the profitability of investments overall
will be revealed in
a) an increase in the supply of loanable dollars.
b) an increase in the demand for loanable dollars.
c) a decrease in the supply of loanable dollars.
d) a decrease in the demand for loanable dollars.
Explanation: If investments are more profitable, firms will want to get more funds to
invest, so the demand for loanable (borrowed/saved) dollars will increase.
3. When evaluating whether or not to make an investment one should focus on the _____
because doing so takes into account anticipated inflation.
a) nominal interest rate
b) real interest rate
c) exchange rate
d) junk bond rate
Explanation: The real interest rate is the rate of interest after inflation expectations are
accounted for.
4. Suppose your grandmother told you (today) that she had set aside an amount of money
in a savings account baring 3 percent interest that was sufficient to give you a $5,000
graduation present in exactly four years. How much would she have had to set aside?
a) $5,000
b) $5,000 x (1.03)4
c) $5,000 / (1.03)4
d) $5,000 / (1+.034)
Explanation: Present value = Payment/〖(1+r)〗^n where r = interest rate and n = number
of years.
Page 9
5. Using an interest rate of 5 percent, which figure has the largest present value?
a) $5,000
b) $5,050 to be received two years from now
c) $5,075 to be received three years from now
d) $5,500 to be received ten years from now
Explanation: $5,000 today has the highest present value. There is no waiting for the
money.
6. Using an interest rate of 5%, which figure has the smallest present value?
a) $5,000
b) $5,050 to be received two years from now
c) $5,075 to be received three years from now
d) $5,500 to be received ten years from now
Explanation: Present value = Payment/〖(1+r)〗^n where r = interest rate and n = number
of years.
7. The present value of a $1,000 payment received two years from now at 5 percent
annual interest will be less than $900 because of
a) taxes.
b) compounding.
c) withholding.
d) double jeopardy.
Explanation: Compounding is the process where the value of an investment increases
because the earnings on an investment earn interest as time passes. Future value =
Payment × (1 + r)n.
8. A 60-month car loan (where no down payment was made) with a 6 percent interest rate
and a monthly payment of $500 would allow the borrower to buy a
a) $35,500 car.
b) $30,000 car.
c) $25,863 car.
d) $28,200 car.
Explanation: Using Excel: PV(rate,nper,pmt,[fv],[type]) = PV(6%/12,60,500,[fv],[type])
= $25,863.
Short Answer Questions
1. Why is the present value of money to be paid in the future less than the amount to be
paid, but the future value of money invested now and withdrawn later is greater than the
original investment?
2. Why is it that $400 per month paid over five years will not be enough to buy a $24,000
car?
3. Why is there usually a positive relationship between the time a bond will mature (how
long the investor has to wait to get her money) and the interest rate on that bond?
Page 10
Think about This
The amount of principal paid in the early stages of a mortgage is relatively modest. On a
$100,000 loan, at 6 percent for 360 months, the first payment is almost exactly $600 with
$500 going for interest and $100 going toward principal. Before 2008’s financial
meltdown, many new homebuyers were getting “interest-only” mortgages. (They paid
$500 per month for the first five years and then $644 per month thereafter). Do you think
this was a good idea?
Talk about This

College students and young people generally get themselves into credit problems because
they do not fully understand the consequences of borrowing and overestimate their ability
to pay loans back. Should your college censor campus bulletin boards and remove credit
card offers from your mail you receive in residence halls?
Bankruptcy laws prevent people from defaulting on student loans, which means
even if you do declare bankruptcy on your credit card debt, you cannot get out from
money you owe in student loans. Were you aware of this when you took out a student
loan and would that impact your decision to take out a student loan?
Page 11

Issues in Economics Today 8th Edition Guell Solutions Manual

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Issues in Economics Today 8th Edition Guell Solutions Manual

Uploaded by

Copyright:

Available Formats

Issues in Economics Today 8th Edition

Guell Solutions Manual

After reading this chapter you should be able to:

The Market for Money

Examples from This Table

Examples from This Table

Internal Rate of Return

KICK IT UP A NOTCH: RISK AND REWARD

The Yield Curve

Short Answer Questions

Talk about This

You might also like