Tutorial 5

Saving, Investment, and the Financial System

I. Terms

1. financial system
2. financial markets
3. bond
4. stock
5. financial intermediaries
6. mutual fund
7. national saving (saving)
8. private saving
9. public saving
10. budget surplus
11. budget deficit
12. market for loanable funds
13. crowding out

II. Short-Answer Questions

1. Why is it important for people who own stocks and bonds to diversify their
holdings?
2. Explain why a mutual fund is likely to be less risky than an individual stock?
3. What is national saving? What is private saving? What is public saving? How
are these three variables related?
4. What is investment? How is it related to national saving?
5. What is a government budget deficit? How does it affect interest rates,
investment, and economic growth
6. Utilizing the national income identities, if government purchases were to rise,
and if output, taxes, and consumption were to remain unchanged, what would
happen to national saving, investment and growth?

III. Practice problems

1. For each of the following pairs, which bond would you expect to pay a higher
interest rate?
Explain.
a. a bond of the U.S. government or a bond of an East European
government
b. a bond that repays the principal in year 2015 or a bond that repays the
principal in year 2040
c. a bond from Coca-Cola or a bond from a software company you run in
your garage
2. Many wworkers hold large amounts of stock issued by the firms at which they
work. Why do you suppose companies encourage this behavior? Why might a
person not want to hold stock in the company where he works?
3. Explain the difference between saving and investment as defined by a
macroeconomist.
Which of the following situations represent investment? Saving? Explain.
a. Your family takes out a mortgage and buys a new house.
 b. You use your $200 paycheck to buy stock in AT&T.
c. Your roommate earns $100 and deposits it in her account at a bank.
d. You borrow $1,000 from a bank to buy a car to use in your pizza
delivery business.
4. Suppose GDP is $8 trillion, taxes are $1.5 trillion, private saving is $0.5
trillion, and public saving is $0.2 trillion. Assuming this economy is closed,
calculate consumption, government purchases, national saving, and investment.
5. Economists in Funlandia, a closed economy, have collected the following
information about the economy for a particular year:
Y = 10,000
C = 6,000
T = 1,500
G = 1,700
The economists also estimate that the investment function is: I = 3,300 – 100 r,
where r is the country’s real interest rate, expressed as a percentage.
Calculate private saving, public saving, national saving, investment, and the
equilibrium real interest rate.
6. Suppose that Intel is considering building a new chip-making factory.
a. Assuming that Intel needs to borrow money in the bond market, why
would an increase in interest rates affect Intel’s decision about whether
to build the factory?
b. If Intel has enough of its own funds to finance the new factory without
borrowing, would an increase in interest rates still affect Intel’s
decision about whether to build the factory? Explain.
7. Suppose the government borrows $20 billion more next year than this year.
a. Use a supply-and-demand diagram to analyze this policy. Does the
interest rate rise or fall?
b. What happens to investment? To private saving? To public saving? To
national saving? Compare the size of the changes to the $20 billion of
extra government borrowing.

IV. Multiple- Choice Questions

1. Which of the following is an example of equity finance?

a. corporate bonds
b. municipal bonds
c. stock
d. bank loan
e. All of the above are equity finance.

2. Credit risk refers to a bond’s

a. Term to maturity.
b. Probability of default.
c. Tax treatment.
d. Dividend.
e. Price-earnings ratio.

3. A financial intermediary is a middleperson between

a. Labor unions and firms.
b. Husbands and wives.
 c. Buyers and sellers.
d. Borrowers and lenders.

4. National saving (or just saving) is equal to

a. Private saving + public saving.
b. Investment + consumption expenditures.
c. GDP – government purchases.
d. GDP + consumption expenditures + government purchases.
e. None of the above.

5. Which of the following statements is true?

a. A stock index is a directory used to locate information about selected stocks.
b. Longer-term bonds tend to pay less interest than shorter-term bonds.
c. Municipal bonds pay less interest than comparable corporate bonds.
d. Mutual funds are riskier than single stock purchases because the performance
of so many different firms can affect the return of a mutual fund.

6. If government spending exceeds tax collections,

a. There is a budget surplus.
b. There is a budget deficit.
c. Private saving is positive.
d. Public saving is positive.
e. None of the above is true.

7. If GDP = $1,000, consumption = $600, taxes = $100, and government purchases =

$200, how much is saving and investment?
a. saving = $200, investment = $200
b. saving = $300, investment = $300
c. saving = $100, investment = $200
d. saving = $200, investment = $100
e. saving = $0, investment = $0

8. If the public consumes $100 billion less and the government purchases $100
billion more (other things unchanging), which of the following statement is true?
a. There is an increase in saving, and the economy should grow more quickly.
b. There is a decrease in saving, and the economy should grow more slowly.
c. Saving is unchanged.
d. There is not enough information to determine what will happen to saving.

9. Which of the following financial market securities would likely pay the highest
interest rate?
a. a municipal bond issued by the state of Texas
b. a mutual fund with a portfolio of blue chip bonds
c. a bond issued by a blue chip company
d. a bond issued by a start-up company

10. Investment is
a. The purchase of stock and bonds.
b. The purchases of capital equipment and structures.
c. when we place our saving in the bank
 d. The purchase of goods and services.

11. If Americans become more thrifty, we would expect

a. The supply of loanable funds to shift to the right and the real interest rate to
rise.
b. The supply of loanable funds to shift to the right and the real interest rate to
fall.
c. The demand for loanable funds to shift to the right and the real interest rate to
rise.
d. The demand for loanable funds to shift to the right and the real interest rate to
fall.

12. Which of the following sets of government policies is the most growth oriented?
a. lower taxes on the returns to saving, provide investment tax credits, and lower
the deficit
b. lower taxes on the returns to saving, provide investment tax credits, and
increase the deficit
c. increase taxes on the returns to saving, provide investment tax credits, and
lower the deficit
d. increase taxes on the returns to saving, provide investment tax credits, and
increase the deficit

13. An increase in the budget deficit that causes the government to increase its
borrowing
a. Shifts the demand for loanabble funds to the right.
b. Shifts the demand for loanabble funds to the left.
c. Shifts the supply of loanable funds to the left.
d. Shifts the supply of loanable funds to the right.

14. An increase in the budget deficit will

a. Raise the real interest rate and decrease the quantity of loanable funds
demanded for investment.
b. Raise the real interest rate and increase the quantity of loanable funds
demanded for investment.
c. Lower the real interest rate and increase the quantity of loanable funds
demanded for investment.
d. Lower the real interest rate and decrease the quantity of loanable funds
demanded for investment.

15. If the supply of loanable funds is very inelastic (steep), which policy would likely
increase saving and investment the most?
a. an investment tax credit
b. a reduction in the budget deficit
c. an increase in the budget deficit
d. none of the above

16. An increase in the budget deficit is

a. A decrease in public saving.
b. An increase in public saving.
c. A decrease in private saving.
 d. An increase in private saving.
e. None of the above.

17. If an increase in the budget deficit reduces national saving and investment, we
have witnessed a demonstration of
a. Equity finance.
b. The mutual fund effect.
c. Intermediation.
d. Crowding out.

18. If Americans become loss concerned with the future and save less at each real
interest rate,
a. Real interest rates fall and investment falls.
b. Real interest rates fall and investment rises.
c. Real interest rates rise and investment falls.
d. Real interest rates rise and investment rises.

19. If the government increases investment tax credits and reduces taxes on the return
to saving at the same time,
a. The real interest rate should rise.
b. The real interest rate should fall.
c. The real interest rate should not change.
d. The impact on the real interest rate is indeterminate.

20. An increase in the budget surplus

a. Shifts the demand for loanable funds to the right and increases the real interest
rate.
b. Shifts the demand for loanable funds to the left and reduces the real interest
rate.
c. Shift the supply for loanable funds to the left and increases the real interest
rate.
d. Shift the supply for loanable funds to the right and reduces the real interest
rate.