Macroeconomics Australia 7th Edition Mctaggart Solutions Manual

Macroeconomics Australia 7th Edition
McTaggart Solutions Manual

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21
C h a p t e r
FINANCE, SAVING
AND INVESTMENT
Answers to the Review Quizzes

Page 474
1. Distinguish between physical capital and financial capital and give two examples of each.
Physical capital is the actual tools, instruments, machines, buildings and other items that have been
produced in the past and are presently used to produce goods and services. Financial capital is the
funds that businesses use to acquire their physical capital. Examples of physical capital are the pizza
ovens owned by Pizza Hut and the buildings in which the Pizza Huts are located. Examples of
financial capital are the bonds issued by Pizza Hut to buy pizza ovens and the loans Pizza Hut has
made to fund their purchases of new buildings.
2. What is the distinction between gross investment and net investment?
Gross investment is the total amount spent on new capital; net investment is the change in the capital
stock. Net investment equals gross investment minus depreciation.
3. What are the three main types of markets for financial capital?
The main types of markets for financial capital are the loan markets, the bond markets and the stock
markets.
4. Explain the connection between the price of a financial asset and its interest rate.
There is an inverse relationship between the price of a financial asset and its interest rate. When the
price of a financial asset rises, its interest rate falls. Similarly, when the interest rate on an asset falls,
the price of the asset rises.
Page 479
1. What is the loanable funds market?
The loanable funds market is the market in which households, firms, governments, banks and other
financial institutions borrow and lend. It is the aggregate of all the individual financial markets and
includes loan markets, bond markets and stock markets. The real interest rate is determined in this
market.
2. Why is the real interest rate the opportunity cost of loanable funds?
The real interest rate is the opportunity cost of loanable funds because the real interest rate measures
what is forgone by using the funds. If the funds are loaned, then the real interest rate is received. If the
funds are borrowed, then the real interest is paid for the funds. The real interest rate forgone when
funds are used either to buy consumption goods and services or to invest in new capital goods is the
opportunity cost of not saving or not lending those funds.
© 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442550773/McTaggart/Economics/7e
FINANCE, SAVING AND INVESTMENT 2
3. How do firms make investment decisions?

To determine the quantity of investment, firms compare the expected profit rate from an investment to
the real interest rate. The expected profit from an investment is the benefit from the investment. The
real interest rate is the opportunity cost of investment. If the expected profit from an investment
exceeds the cost of the real interest rate, then firms make the investment. If the expected profit from an
investment is less than the cost of the real interest rate, then firms do not make the investment.
4. What determines the demand for loanable funds and what makes it change?
The demand for loanable funds depends on the real interest rate and expected profit. If the real interest
rate falls and nothing else changes, the quantity of loanable funds demanded increases. Conversely, if
the real interest rate rises and everything else remains the same, the quantity of loanable funds
demanded decreases. Movements along the loanable funds demand curve illustrate these events. If the
expected profit increases and nothing else changes, the demand for loanable funds increases and the
demand for loanable funds curve shifts rightward. If the expected profit decreases and everything else
remains the same, the demand for loanable funds decreases and the demand for loanable funds curve
shifts leftward.
5. How do households make saving decisions?
A household’s saving depends on five factors: the real interest rate, the household’s disposable
income, the household’s expected future income, wealth and default risk. A household increases its
saving if the real interest rate increases, its disposable income increases, its expected future income
decreases, its wealth decreases or if default risk decreases.
6. What determines the supply of loanable funds and what makes it change?
The supply of loanable funds depends on the real interest rate, disposable income, expected future
income, wealth and default risk. An increase in the real interest rate increases the quantity of loanable
funds supplied; a decrease in the real interest rate decreases the quantity of loanable funds supplied. An
increase in disposable income increases the supply of loanable funds; a decrease in disposable income
decreases the supply of loanable funds. An increase in wealth decreases the supply of loanable funds; a
decrease in wealth increases the supply of loanable funds. An increase in expected future income
decreases the supply of loanable funds; a decrease in expected future income increases the supply of
loanable funds. Finally, an increase in default risk decreases the supply of loanable funds; a decrease in
default risk increases the supply of loanable funds.
7. How do changes in the demand for and supply of loanable funds change the real interest rate and
quantity of loanable funds?
The real interest rate is determined by the supply of loanable funds and the demand for loanable funds.
The equilibrium real interest rate is the real interest rate at which the quantity of loanable funds
supplied equals the quantity of loanable funds demanded. Changes in the demand for or supply of
loanable funds change the equilibrium real interest rate and equilibrium quantity of loanable funds. If
the demand for loanable funds increases and the supply does not change, the real interest rate rises and
the quantity of loanable funds increases. If the demand for loanable funds decreases and the supply
does not change, the real interest rate falls and the quantity of loanable funds decreases. If the supply
of loanable funds increases and the demand does not change, the real interest rate falls and the quantity
of loanable funds increases. If the supply of loanable funds decreases and the demand does not change,
the real interest rate rises and the quantity of loanable funds decreases.
Page 482
1. How does a government budget surplus or deficit influence the loanable funds market?
A government budget surplus adds to the supply of loanable funds. A government budget deficit adds
to the demand for loanable funds.
2. What is the crowding-out effect and how does it work?
The crowding out effect refers to the decrease in investment that occurs when the government budget
deficit increases. An increase in the government budget deficit increases the demand for loanable
funds. As a result the real interest rate rises. The rise in the real interest rate decreases—“crowds
out”—investment.
3. What is the Ricardo–Barro effect and how does it modify the crowding-out effect?
The Ricardo–Barro effect points out that the crowding out effect is less than predicted by looking only
at the effect of a budget deficit on the demand for loanable funds. The Ricardo–Barro effect asserts
that as a result of a government budget deficit households increase their saving to pay the higher taxes
that will be needed in the future to repay the debt issued to fund the deficit. The increase in saving
increases the supply of loanable funds. This increase in the supply of loanable funds offsets the rise in
the real interest rate from the increase in the demand for loanable funds caused by the budget deficit.
Because the real interest rate does not rise as much, the decrease in investment, that is the amount of
crowding out, is less in the presence of the Ricardo–Barro effect.
Page 485
1. Why do loanable funds flow among countries?
Loanable funds flow among countries because savers are searching for the highest (risk-adjusted) real
interest rate and borrowers are searching for the lowest (risk-adjusted) real interest rate.
2. What determines the demand for and supply of loanable funds in an individual economy?
The demand for and supply of loanable funds in an economy with international lending and borrowing
depend on the same factors as in an economy without international lending and borrowing with one
exception: Demand is determined by the country’s demand but supply is determined by the world
supply. In particular, if at the world real interest rate, the country has a surplus of funds, it can lend the
surplus to the rest of the world while if at the world real interest rate, the country has a shortage of
funds, it can borrow from the rest of the world.
3. What happens if a country has a shortage of loanable funds at the world real interest rate?
If a country has a shortage of loanable funds at the world real interest rate, it borrows from other
nations and becomes an international borrower.
4. What happens if a country has a surplus of loanable funds at the world interest rate?
If a country has a surplus of loanable funds at the world real interest rate, it loans to other nations and
becomes an international lender.
5. How is a government budget deficit financed in an open economy?
A government budget deficit increases the demand for loanable funds. In an open economy, the
increase in the demand for loanable funds means the country lends less to the rest of the world (if it
initially was an international lender) or borrows more from the rest of the world (if it initially was an
international borrower). These changes in lending or borrowing finance the budget deficit.
Answers to the Study Plan Problems and Applications

Use the following information to work Problems 1 and 2.
Michael is an Internet service provider. On 31 December 2011, he bought an existing business with
servers and a building worth $400,000. During his first year of operation, his business grew and he
bought new servers for $500,000. The market value of some of his older servers fell by $100,000.
1. What was Michael’s gross investment, depreciation and net investment during 2012?
Michael’s gross investment was $500,000, his depreciation was $100,000 and his net investment was
$400,000.
2. What is the value of Michael’s capital at the end of 2012?
Michael’s capital at the end of 2012 is equal to his capital at the beginning of 2010, $400,000, plus his
net investment during the year, also $400,000, for a total of $800,000.
3. Lori is a student who teaches golf on the weekend and in a year earns $20,000 after paying her
taxes. At the beginning of 2012, Lori owned $1,000 worth of books, CDs and golf clubs and she
had $5,000 in a savings account at the bank. During 2012, the interest on her savings account
was $300 and she spent a total of $15,300 on consumption goods and services. There was no
change in the market values of her books, CDs and golf clubs.
a. How much did Lori save in 2012?
Lori’s saving equals her disposable income minus her consumption expenditure. Lori’s disposable
income is $20,000 plus the interest on her savings account, $300, for a total of $20,300. Her
consumption expenditure is $15,300, so her saving is $5,000.
b. What was her wealth at the end of 2012?
Lori’s wealth at the end of 2012 is equal to the value of her wealth at the beginning of 2012 plus her
saving during the year. At the beginning of 2012 Lori’s wealth is $6,000—the value of her books,
CDs, golf clubs and savings account. Lori saved $5,000 during 2012 so her wealth at the end of 2012
is $11,000.
4. Household Balance Sheet in Bad Shape
Economics editor Michael Stutchbury thinks household finances are in bad shape. He says that
the boom in resources enabled the Australian government to pay off its debts but encouraged
Australian households to go ever deeper into debt. “Over the past decade, the debt burden on
Australian households doubled to 160 per cent of household income.” But with the world
economy in recession and share prices down by billions and the value of superannuation funds,
Australians are suddenly poorer. “Overborrowing and overspending got us into this fix. It
stretches … [belief ] … that even more borrowing from a less bountiful future to consume now
provides the solution …”
Source: The Australian, 10 February 2009
a. How does a household go into debt? In which financial markets and from what types of
financial institutions does it borrow?
Households go into debt to finance the purchase of big ticket items such as cars and household
appliances. They get their finance as loans from banks, often as outstanding credit card balances and
finance companies. Households also go into debt to buy new homes usually as a loan that is secured by
a mortgage. All of these types of financing take place in loan markets.
b. How does the Australian government go into debt? In which financial markets and from what
types of financial institutions does it borrow?
Governments borrow funds to finance government deficit spending by selling bonds in the bond
market. The buyer of a government bond makes a loan to the government and is entitled to the
payments promised by the bond.
5. Outlook for Australian Banks
An Australian bank that has $100 in assets will now need about $6.00 of capital or shareholders
equity to maintain its banking licence. Australian banks have substantial low-risk mortgage
assets. Banks with more risky assets require a capital ratio of 8 per cent.The G-20 aims to take
stock of the G-20 economic recovery. One achievement in Pittsburgh could be a deal to require
that financial institutions hold more capital.
Source: Australian Investors Association Equities
Bulletin, Issue 54, May 2010
What exactly is the “capital” referred to in the news clip? What is the risk that makes it necessary
for banks to hold “capital”? How might the requirement to hold more capital make a bank safer?
The “capital” referred to in the news clip is the financial institution’s net worth to its shareholders, not
its physical capital. By holding more capital—net worth—the firms are less likely to become insolvent.
By making the firms less likely to become insolvent, the G-20 was prescribing a policy that would
make them safer.
First Call, Inc., is a mobile phone company. It plans to build an assembly plant that costs $10
million if the real interest rate is 6 per cent a year. If the real interest rate is 5 per cent a year,
First Call will build a larger plant that costs $12 million. And if the real interest rate is 7 per cent
a year, First Call will build a smaller plant that costs $8 million.
6. Draw a graph of First Call’s demand for
loanable funds curve.
Figure 21.1 shows First Call’s demand for
7. First Call expects its profit from the sale of
mobile phones to double next year. If other
things remain the same, explain how this
increase in expected profit influences First
Call’s demand for loanable funds.
When First Call expects its profit to increase,
First Call increases its investment. The increase
in its investment leads First Call to increase its
demand for loanable funds.
8. Draw a graph to illustrate how an increase in the

supply of loanable funds and a decrease in the
demand for loanable funds can lower the real
interest rate and leave the equilibrium quantity of
loanable funds unchanged.
Figure 21.2 shows the effect of an increase in the
supply of loanable funds and a decrease in the
demand for loanable funds. The supply of loanable
funds curve shifts rightward from SLF0 to SLF1,
and the demand for loanable funds curve shifts
leftward from DLF0 to DLF1. The magnitude of
the increase in supply is equal to the magnitude of
the decrease in demand, so the real interest rate
falls (from 7 per cent to 4 per cent in the figure)
and the quantity of loanable funds does not change
(staying at $2.5 trillion in the figure).
9. Use the information in Problem 4.
a. Explain how Australian household wealth
influences saving. In view of the facts reported
here, would you expect saving to increase?
If a household’s wealth increases because of a capital gain, the household sees less need to save. For
example if the value of their homes increase with rising house prices, household saving rates drop as a
percentage of income. With the world economy in recession and the value of shares and
superannuation funds down by billions Australian households have suffered capital losses and are now
poorer. With a loss of net worth households can be expected to increase savings rates to restore their
wealth.
b. When a household buys a new house and pays for it with a mortgage, does the purchase
represent consumption, saving or investment, and how does it affect the demand for and supply
of loanable funds?
Households get finance to buy new homes usually by getting a loan from a bank secured by a
mortgage. Expenditure on new homes is counted as part of investment and financing the purchase of
the home increases the demand for loanable funds.
Use the table to work Problems 10 to 12. The Loanable Loanable funds
table shows an economy’s demand for loanable Real interest rate funds supplied
funds and the supply of loanable funds demanded
schedules, when the government’s budget is
balanced. (per cent per (billions of 2009/10 dollars)
10. Suppose that the government has a budget year)
surplus of $1 billion. What are the real 4 8.5 5.5
interest rate, the quantity of investment 5 8.0 6.0
and the quantity of private saving? Does 6 7.5 6.5
any crowding out occur? 7 7.0 7.0
The real interest rate is 6 per cent, the
8 6.5 7.5
quantity of investment is $7.5 billion, and 9 6.0 8.0
the quantity of private saving is $6.5 10 5.5 8.5
billion. There is no crowding out.

11. Suppose that the government has a budget deficit of $1 billion. What are the real interest rate, the
quantity of investment and the quantity of private saving? Does any crowding out occur?
The equilibrium real interest rate becomes 8 per cent, the quantity of investment is $6.5 billion, and the
quantity of private saving is $7.5 billion. There is crowding out of $500 million of investment.
12. Suppose that the government has a budget deficit of $1 billion and the Ricardo–Barro effect
occurs, what are the real interest rate and the quantity of investment?
The equilibrium real interest rate remains 7 per cent and the quantity of investment remains $7.0
billion. There is no crowding out because the $1 billion increase in the budget deficit leads to an
offsetting $1 billion increase in private saving.
Use the table in Problem 10 to work Problems 13 to 15.
Suppose that the quantity of loanable funds demanded increases by $1 billion at each real interest rate
and the quantity of loanable funds supplied increases by $2 trillion at each interest rate.
13. If the government budget is balanced, Real interest Loanable Loanable funds
what are the real interest rate, the rate funds supplied
quantity of loanable funds, investment demanded
and private saving? Does any (per cent per (billions of 2009/10 dollars)
crowding out occur? year)
The table to the right, which shows the 4 9.5 7.5
new demand for loanable funds and 5 9.0 8.0
new supply of loanable funds 6 8.5 8.5
schedules, is helpful to answer the 7 8.0 9.0
problem. The new real interest rate is 8 7.5 9.5
6 per cent, and the quantity of 9 7.0 10.0
loanable funds, private saving and 10 6.5 10.5
investment are all $8.5 billion. There
is no crowding out.
14. If the government budget becomes a deficit of $1 billion, what are the real interest rate, the
quantity of loanable funds, investment and private saving? Does any crowding out occur?
The equilibrium real interest rate becomes 7 per cent. The equilibrium quantity of loanable funds is
$9.0 billion, the equilibrium quantity of investment is $8.0 billion, and the equilibrium quantity of
private saving is $9.0 billion. There is crowding out of $500 million of investment.
15. If the government wants to stimulate investment and increase it to $9 billion, what must it do?
Assuming no Ricardo–Barro effect, the government needs to have a budget surplus of $1 billion. In
this case, the new equilibrium is at a real interest rate of 5 per cent. The quantity of investment is $9
billion and the quantity of private saving is $8 billion.

Global Saving Glut and U.S. Current Account, remarks by Ben Bernanke (when a governor of the
Federal Reserve) on 10 March 2005:
The U.S. economy appears to be performing well: Output growth has returned to healthy levels, the
labour market is firming, and inflation appears to be under control. But, one aspect of U.S. economic
performance still evokes concern: the nation’s large and growing current account deficit (negative net
exports). Most forecasters expect the nation’s current account imbalance to decline slowly at best,
implying a continued need for foreign credit and a concomitant decline in the U.S. net foreign asset
position.
16. Why is the United States, with the world’s largest economy, borrowing heavily on international
capital markets—rather than lending, as would seem more natural?
At the world real interest rate the quantity of loanable funds demanded in the United States exceeds the
quantity of loanable funds supplied. The surprising aspect of this point is that the quantity of loanable
funds is low in the United States because U.S. disposable income is so high. Investment is funded by
household saving, the government budget surplus and borrowing from the rest of the world, so that I =
S + (T – G) + (M – X). Foreigners might be eager to make investments in the United States, perhaps
because the investment is more productive or perhaps safer than elsewhere in the world. If this is the
situation, then the supply of loanable funds by foreigners to the United States is greater than would
otherwise be the case, which would lead to a lower U.S. real interest and a greater quantity of funds
borrowed from abroad.
17. a. What implications do the U.S. current account deficit (negative net exports) and our reliance on
foreign credit have for economic performance of the U.S. economy?
The United States is borrowing from abroad to meet the demand for loanable funds. With the
borrowing, the quantity of loanable funds in the United States is larger than otherwise, which means
that the quantity of investment projects funded is larger than otherwise. As a result, the U.S. capital
stock is larger than otherwise, which helps enhance U.S. economic performance. However, the United
States will need to repay its loans from the rest of the world and this repayment will detract from U.S.
citizens’ wellbeing.
b. What policies, if any, should be used to address this situation?
If the goal is to decrease U.S. borrowing from abroad, then either the U.S. demand for loanable funds
needs to decrease or the U.S. supply of loanable funds needs to increase. Increasing the quantity of
U.S. loanable funds seems to be the more reasonable policy, so policy proposals need to focus on
increasing savings. Government policies to boost private saving might include tax policies that exempt
the return from saving from taxation. Additionally government policies that decrease the size of the
budget deficit and perhaps move the government budget to a surplus also would decrease U.S.
borrowing from abroad.
18. IMF Readies Rescue Plan for Italy

The International Monetary Fund (IMF) has prepared a rescue plan worth up to 600 billion euros
($A827 billion). The market interest rate on two-year and five-year Italian government bonds has
risen above 7 per cent per year but the IMF would guarantee interest rates of 4 per cent or 5 per
cent per year on its loan.
Source: ninemsn.com.au, 27 November 2011
a. Explain how an IMF loan to Italy influences the global loanable funds market.
The IMF loan to Italy as part of a rescue
FIGURE 21.3
package means Italy will not have to
borrow funds on global capital markets and Problem 18b
will lower the demand for loanable funds.
Real interest rate (per cent per year)

The IMF receives the funds it lends from
6.5 SLFW
the quota subscriptions paid in by its
member countries.
6.0
b. On a graph illustrate the effects.
5.5
Figure 21.3 shows the demand for loanable
funds without the IMF rescue package for 5.0
Italy as DLFW1. The Italian Government
would need to refinance its debt by 4.5
borrowing funds on global capital markets DLFW1
at rates above 7%. The demand for 4.0
loanable funds with the IMF rescue DLFW2
package is DLFW2. With the loan from the
IMF there will no longer be a demand for 0
funds from the Italian Government on 9.0 9.5 10.0 10.5 11.0 11.5
global markets. Loanable funds (trillions of dollars)
Answers to the Additional Problems and Applications

19. On 1 January 2011, Terry’s Towing Service owned 4 tow trucks valued at $300,000. During
2011, Terry’s bought 2 new trucks for a total of $180,000. At the end of 2011, the market value
of all of the firm’s trucks was $400,000. What was Terry’s gross investment? Calculate Terry’s
depreciation and net investment.
His gross investment was $180,000. His depreciation was $80,000. His net investment, equal to gross
investment minus depreciation, was $100,000.
The Australian Bureau of Statistics reported that the capital stock was $2,820 billion at the end of
2005/06, $3,078 billion at the end of 2006/07, and $3,388 billion at the end of 2007/08. Depreciation in
2006/07 was $41 billion, and gross investment during 2007/08 was $336 billion.
20. Calculate Australian net investment and gross investment during 2006/07.
Net investment equals the change in the capital stock. In 2006/07, Australian net investment was
$3,078 billion − $2,820 billion, which is $258 billion. Gross investment equals net investment plus
depreciation. In 2006/07, Australian gross investment was $258 billion + $41 billion, which is $299
billion.
21. Calculate Australian depreciation and net investment during 2007/08.
Net investment equals the change in the capital stock. In 2007/08, Australian net investment was
$3,388 billion − $3,078 billion, which is $310 billion. Depreciation equals gross investment minus net
investment. In 2007/08, Australian depreciation was $336 billion − $310 billion, which is $26 billion.
22. Annie runs a fitness centre. On 31 December 2011, she bought an existing business with exercise
equipment and a building worth $300,000. During 2012, business improved and she bought some
new equipment for $50,000. At the end of 2012, her equipment and buildings were worth
$325,000. Calculate Annie’s gross investment, depreciation and net investment during 2012.
Annie’s net investment during 2012 is $25,000 because that is the change in her capital stock. Annie’s
gross investment is $50,000 because that is her total purchase of capital equipment in 2012. Annie’s
depreciation during 2012 is $25,000 because Annie’s net investment, $25,000, equals her gross
investment, $50,000, minus her depreciation.
23. Karrie is a golf pro, and after she paid taxes, her income from golf and interest from financial
assets was $1,500,000 in 2012. At the beginning of 2012, she owned $900,000 worth of financial
assets. At the end of 2012, Karrie’s financial assets were worth $1,900,000.
a. How much did Karrie save during 2012?
Karrie’s wealth increased by $1,000,000 in 2010. So her saving in 2010 is $1,000,000. (This answer
assumes no capital gains or losses on her stocks and bonds.)
b. How much did she spend on consumption goods and services?
Her income after taxes was $1,500,000. Her consumption equals her income minus her saving, which
is $1,500,000 − $1,000,000 = $500,000.

In 2012, the Lee family had disposable income of $80,000, wealth of $140,000, and an expected future
income of $80,000 a year. At a real interest rate of 4 per cent a year, the Lee family saves $15,000 a
year; at a real interest rate of 6 per cent a year, they save $20,000 a year; and at a real interest rate of 8
per cent, they save $25,000 a year.
24. Draw a graph of the Lee family’s supply of loanable funds curve.
Figure 21.4 shows the Lee family’s supply of
25. In 2013, suppose that the stock market crashes and
the default risk increases. Explain how this increase
in default risk influences the Lee family’s supply of
If default risk increases the Lee family will decrease
its saving. As a result, the Lee family’s supply of
loanable funds decreases and its supply of loanable
funds curve shifts leftward.
26. Draw a graph to illustrate the effect of an increase in
the demand for loanable funds and an even larger
increase in the supply of loanable funds on the
equilibrium quantity of loanable funds and the real
interest rate.
Figure 21.5 shows the effect of an increase in the
demand for loanable funds and an even larger
increase in the supply of loanable funds. The demand
curve shifts rightward from DLF0 to DLF1, and the
supply curve shifts rightward from SLF0 to SLF1.
The increase in supply is larger than the increase in
demand, so the real interest rate falls (from 6 per cent
to 5 per cent in the figure) and the quantity of
loanable funds increases (from $2.3 trillion to $2.7
trillion in the figure).
27. Greenspan’s Conundrum Spells Confusion for Us All

In January 2005, the interest rate on bonds was 4% a year and it was expected to rise to 5% a
year by the end of 2005. As the rate rose to 4.3% during February, most commentators focused,
not on why the interest rate rose, but on why it was so low before. Explanations of this
“conundrum” included that unusual buying and expectations for an economic slowdown were
keeping the interest rate low.
Source: Financial Times, 26 February 2005
a. Explain how “unusual buying” might lead to a low real interest rate.
“Unusual buying” means that the demand in the financial bond market is “unusually” large. In this
case, the unusually large demand leads to bond prices being unusually high. Higher bond prices mean
a lower interest rate on the asset. So unusually high bond prices creates unusually low interest rates on
bonds.
b. Explain how investors’ “expectations for an economic slowdown” might lead to a lower real
interest rate.
Investors’ expectations of an economic slowdown mean that the expected profit from investing in
capital falls. The lower expected profit decreases the demand for investment, which decreases the
demand for loanable funds. The fall in the demand for loanable funds then lowers the equilibrium real
interest rate.
India’s Economy Hits the Wall
At the start of 2008, India had an annual growth of 9%, huge consumer demand, and increasing foreign
investment. But by July 2008, India had 11.4% inflation, large government deficits, and rising interest
rates. Economic growth is expected to fall to 7% by the end of 2008. A Goldman Sachs report suggests
that India needs to lower the government's deficit, raise educational achievement, control inflation, and
liberalise its financial markets.
Source: Business Week, 1 July 2008
28. If the Indian government reduces its deficit and returns to a balanced budget, how will the
demand for or supply of loanable funds in India change?
If the Indian government reduces its deficit, the demand for loanable funds decreases.
29. With economic growth forecasted to slow, future incomes are expected to fall. If other things
remain the same, how will the demand or supply of loanable funds in India change?
If expected future incomes slow, the major effect is an increase in the supply of loanable funds as
households increase their saving.
30. Australian Debt and Deficit

The Australian government reported that in financial year 2011/12 it expected to receive $336
billion and spend $370 billion. It expected its outstanding debt at the end of the year to be $133
billion or 8.9 per cent of GDP.
Source: Australian Government Budget
Explain the effect of the government deficit and debt on Australian economic growth.
The government deficit increases the demand for loanable funds and, in the absence of a Ricardo–
Barro effect, raises the real interest rate and crowds out investment. The decrease in investment means
that Australian capital stock is lower than would otherwise be the case, which will decrease Australian
economic growth.
31. Bernanke’s Asian Savings Glut Theory Blasted
U.S. Federal Reserve chairman Ben Bernanke says that high saving rates in Asia (that he called a
“glut of savings”) were to blame for the extraordinarily low bond rates during the first half of the
“noughties”, as well as U.S. soaring house prices and current account deficit. Claudio Borio,
research director at the Bank for International Settlements, says Bernanke is wrong and excessive
lending by financial institutions caused low interest rates.
Source: The Australian, 6 June 2011
a. Graphically illustrate and explain the impact of the “glut of savings” on the real interest rate
and the quantity of loanable funds.
Figure 21.6 shows the global loanable funds
market. In the world loanable funds market the
supply of loanable funds—the so-called “glut of
savings”—has significantly increased the supply
of loanable funds. The supply curve shifts
rightward from SLF0 without the “glut” to SLF1
with it. The increase in the supply of loanable
funds lowers the real interest rate, in the figure
from 6 per cent to 4 per cent, and increases the
quantity of loanable funds, in the figure from $13
trillion to $15 trillion.
b. How do the high saving rates in Asia impact
investment in other countries?
The high savings rates in Asia increase the world
supply of loanable funds and lower the world real
interest rate. The lower global real interest rate
lowers the real interest rate in other countries.
Investment in other countries increases because of
the lower real interest rate available in the global loanable funds market.
Use the following information to work Problems 32 to 35.

Most economists agree that the problems we are
witnessing today developed over a long period of time.
For more than a decade, a massive amount of money
flowed into the United States from investors abroad,
because the U.S. economy is an attractive and secure
place to do business. This large influx of money to
U.S. financial institutions—along with low interest
rates—made it easier for people to get credit. These
developments allowed more families to borrow money
for cars and homes and college tuition—some for the
first time. They allowed more entrepreneurs to get
loans to start new businesses and create jobs.
President George W. Bush, Address to the Nation, 24

September 2008
32. Explain why, for more than a decade, a massive
amount of money flowed into the United States.
Compare and contrast your explanation with that of the President.
Financial funds flow throughout the world seeking the highest risk-adjusted return. The risk-adjusted
real interest rate in the United States was higher than that in many other countries so funds flowed
vigorously into the United States. Mr Bush’s explanation was similar but did not point out the
desirability of investing in the United States because of the higher risk-adjusted interest rate.
33. Provide a graphical analysis of the reasons why the interest rate was low.
Figure 21.7 shows the U.S. loanable funds market and the world real interest rate, assumed to be 4 per
cent. In the figure, if there was no international lending and borrowing the real interest rate in the
United States would be 6 per cent, the interest rate that sets the quantity of loanable funds demanded in
the United States equal to the quantity supplied. However the United States can borrow from abroad.
When the United States borrows from abroad, the real interest rate equals the world real interest. In the
figure the real interest rate in the United States is 4 per cent and the United States borrows $0.5 trillion
from the rest of the world.
34. Funds have been flowing into the United States since the early 1980s.Why might they have
created problems in 2008 but not earlier?
The financial landscape was different in 2008 than in earlier years. By 2008 the quantity of mortgage
loans in the United States had exploded over the past few years. Additionally in 2008 the real interest
rate had risen and many homeowners were unable to make the scheduled repayments on their
mortgages. They defaulted on their mortgages and by so doing drove many financial firms into
insolvency. Compared to previous years, 2008 was unique and hence a financial crisis occurred in
2008 rather than in earlier years.
35. Could the United States stop funds from flowing in from other countries? How?
The United States could stop funds from flowing in from other countries. The United States could try
to do so directly by forbidding borrowing from abroad. However the United States would probably be
more successful if it could either decrease the demand for loanable funds (perhaps by decreasing the
government budget deficit) and/or increase the supply of loanable funds (perhaps by giving saving a
more favourable tax treatment). In this case the United States could become a net foreign lender of
funds.
Economics in the News

36. After you have studied Reading Between the Lines on pp. 486–87 answer the following
questions.
a. What was happening in Europe in 2011 that created stress in financial markets?
The fear that governments in Greece, Spain and Italy might become insolvent and not repay their debts
has decreased supply in the global loanable funds market and raised the real interest rate.
b. How did the events you’ve described in part (a) influence the demand for and supply of
loanable funds in the global loanable funds market?
The need for European governments to fund budget deficits increased the demand for loanable funds
and afraid that they might not get repaid, lenders held back and the supply of loanable funds decreased.
The increase in demand and fall in supply increased the real rate of interest on global funds markets.
c. How did the events you’ve described in part (a) influence the demand for and supply of
loanable funds in the Australian loanable funds market?
The demand for loanable funds in Australia and supply of loanable funds from Australia do not change
directly from the tightness of credit in the global loanable funds market. The higher interest rate in the
global market for funds will increase the quantity of loanable funds supplied in Australia (a move up
along the supply of loanable funds curve) and decrease the quantity of loanable funds demanded in
Australia (a move up along the demand for loanable funds curve).
d. How did the developments in Europe affect interest rates paid and received by Australian banks
and other borrowers and lenders?
The real interest rate rose. Australian banks currently get 30 per cent of their funds from the rest of the
world and will pay higher interest rates for these funds and higher interest rates for Australian savings.
Australian businesses and consumers will face higher interest rates when they borrow from banks.
e. Illustrate your answers to parts (b), (c) and (d) with an appropriate graphical analysis of the
global loanable funds market and the loanable funds market in Australia
FIGURE 21.8a FIGURE 21.8b

Problem 36e Problem 36e
8 8

SLF Aust
7 SLF1 7
SLF0
6 6
5 5 SLF1
4 4
3 3
2 2 SLF0
1 1
DLF0 DLF1 DLF Aust
0 Q1 Q0 0 q0 q1 q1/ q0 /
Loanable funds (trillions of dollars) Loanable funds (billions of dollars)
Figure 21.8a shows the global market for loanable funds and Figure 21.8b shows the Australian market
for loanable funds. In Figure 21.8a, the turmoil in European financial markets has decreased the supply
of loanable funds and the supply curve shifts leftward from SLF0 to SLF1. The demand for loanable
funds by European governments shifts the demand curve rightwards from DLF0 to DLF1. The increase
in demand and fall in supply increases the real rate of interest in the global loanable funds market from
2 per cent to 5 per cent.
The increase in the global interest rate increased the interest rate in Australia, a net borrower of global
funds. Figure 21.8b shows that in Australia before the financial crisis interest rates were 2 per cent and
Australian financial institutions were borrowing q0/ - q0. When the interest rate rose on global funds
markets from 2 per cent to 5 per cent the quantity of loanable funds demanded in Australia fell from q 0/
to q1/ and the quantity of loanable funds supplied increased from q 0 to q1. The quantity of funds
borrowed by Australian financial institutions after the rise in global interest rates is q 1/ - q1.

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McTaggart Solutions Manual

Answers to the Review Quizzes

3. How do firms make investment decisions?

Answers to the Study Plan Problems and Applications

8. Draw a graph to illustrate how an increase in the

billion. There is no crowding out.

Use the following information to work Problems 16 and 17.

18. IMF Readies Rescue Plan for Italy

Real interest rate (per cent per year)

Answers to the Additional Problems and Applications

Use the following information to work Problems 24 and 25.

27. Greenspan’s Conundrum Spells Confusion for Us All

30. Australian Debt and Deficit

Use the following information to work Problems 32 to 35.

President George W. Bush, Address to the Nation, 24

Economics in the News

FIGURE 21.8a FIGURE 21.8b

Real interest rate (per cent per year)

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