Office Hours: Monday 3:00-4:00 – LUMS C85 ECON 101 Tutorial: Week 16 Shane Murphy s.murphy5@lancaster.ac.uk Office Hours: Monday 3:00-4:00 – LUMS C85

Outline Roll Call Problems Game

Chapter 24: Problem 3 Declines in share prices are sometimes viewed as harbingers of future declines in real GDP. Why do you suppose that might be true? Stock prices are viewed as harbingers of future declines in real GDP because people value stocks based on the expected future profitability of the firm. If stock prices fall, this must mean that investors expect a lower future profitability for the firms. This means that we might expect output in these firms to decline as well.

Chapter 24: Problem 4 When the Greek government asked for support from the EU to repay bonds that were coming up for maturity between 2008 and 2010, interest rates rose on bonds issued by a number of other EU countries like Portugal, Spain, and Ireland also rose. Why do you suppose this happened? What can you predict happened to the price of bonds from these countries during this period? When the Greek government asked for support on its debt, investors perceived a higher chance of default (than they had before) on similar bonds sold by other EU countries like Spain, Ireland and Portugal. Since investors believe they are less likely to earn back their investment in a bond, they will want a higher interest rate on the bond if they are to make an investment.

Chapter 24: Problem 4 When the Greek government asked for support on its debt, investors perceived a higher chance of default (than they had before) on similar bonds sold by other EU countries like Spain, Ireland and Portugal. Thus the supply of loanable funds shifted to the left, as shown in Figure 1. The result was an increase in the interest rate.

Chapter 24: Problem 7 Suppose GDP is €5 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. We know that Y = 5, T = 1.5, Sprivate = 0.5 = Y - T - C, Spublic = 0.2 = T - G. Since Sprivate = Y - T - C, then rearranging gives C = Y - T - Sprivate = 5 - 1.5 - 0.5 = 3. Since Spublic = T - G, then rearranging gives G = T - Spublic = 1.5 - 0.2 = 1.3. Since S = national saving = Sprivate + Spublic = 0.5 + 0.2 = 0.7. Finally, since I = investment = S, I = 0.7.

Chapter 24: Problem 7 Suppose GDP is €5 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.

Chapter 24: Problem 8 Suppose BP is considering exploring a new oil field a. Assuming BP needs to borrow in the bond market to finance the purchase of new machinery, why would an increase in interest rates affect BPP’s decision about whether to carry out the exploration? If interest rates increase, the costs of borrowing money to invest in the oil field exploration become higher, so the returns from the exploration may not be sufficient to cover the costs. Thus, higher interest rates make it less likely that BP will undertake the exploration.

Chapter 24: Problem 8 b. If BP has enough of its own funds to develop the new field without borrowing, would an increase in the interest rate still affect BP’s decision? Even if BP uses its own funds to finance the exploration, the rise in interest rates still matters. There is an opportunity cost in using the funds. Instead of investing in the factory, BP could use the money to buy bonds to earn the higher interest rate available there. BP will compare its potential returns from oilfield exploration to the potential returns from the bond market. So if interest rates rise, so that bond market returns rise, BP is again less likely to invest in the exploration.

Chapter 24: Problem 9 Suppose the government borrows €5 billion more next year than this year. a. Use supply and demand to analyze this policy, does interest rate rise or fall? Initially, the supply of loanable funds is curve S1, the equilibrium real interest rate is i1, and the quantity of loanable funds is L1. The increase in government borrowing by €5 billion reduces the supply of loanable funds at each interest rate by €5billion, so the new supply curve, S2, is shown by a shift to the left of S1 by exactly €5 billion. As a result of the shift, the new equilibrium real interest rate is i2. The interest rate has increased as a result of the increase in government borrowing.

Chapter 24: Problem 9 b. What happens to investment, to private savings, to public savings, and to national savings. Compare these changes to the €5 billion change in government borrowing. Since the interest rate has increased, investment and national saving decline, and private saving increases. The increase in government borrowing reduces public saving. From the figure you can see that equilibrium level of loanable funds (and thus both investment and national saving) decline by less than €5 billion, while public saving declines by €5 billion and private saving rises by less than €5 billion.

Chapter 24: Problem 9 c. How does the elasticity of the supply of loanable funds affect the size of these changes The more elastic is the supply of loanable funds, the flatter the supply curve would be, so the interest rate would rise by less and thus national saving would fall by less, as Figure 3 shows.

Chapter 24: Problem 9 d. How does the elasticity of the demand for loanable funds affect the size of these changes The more elastic the demand for loanable funds, the flatter the demand curve would be, so the interest rate would rise by less and thus national saving would fall by more, as Figure 4 shows.

Chapter 24: Problem 9 e. Suppose households believe that greater government borrowing implies higher future taxes to pay the debt. What does this belief do to private savings and the supply of loanable funds? If households believe that greater government borrowing today implies higher taxes to pay off the government debt in the future, then people will save more so they can pay the higher future taxes, so private saving will increase, as will the supply of loanable funds. This will offset the reduction in public saving, thus reducing the amount by which the equilibrium quantity of investment and national saving decline, and reducing the amount that the interest rate rises. If the rise in private saving was exactly equal to the increase in government borrowing, there would be no shift in the national saving curve, so investment, national saving, and the interest rate would all be unchanged. (This is the case of Ricardian equivalence.)

Chapter 24: Problem 10 This chapter explains that investment can be increased both by reducing taxes on private savings and by reducing the government budget deficit. a. Why is it difficult to implement both of these policies at the same time? Investment can be increased by reducing taxes on private saving or by reducing the government budget deficit. But reducing taxes on private saving has the effect of increasing the government budget deficit, unless some other taxes are increased or government spending is reduced. So it is difficult to engage in both policies at the same time.

Chapter 24: Problem 10 b. What would you need to know about private saving in order to judge which of these two policies would be a more effective way to raise investment? To know which of these policies would be a more effective way to raise investment, you would need to know: (1) what the elasticity of private saving is with respect to the posttax real interest rate, since that would determine how much private saving would increase if you reduced taxes on saving; (2) how private saving responds to changes in the government budget deficit, since, for example, if Ricardian equivalence holds, the decline in the government budget deficit would be matched by an equal decline in private saving, so national saving would not increase at all; and (3) how elastic investment is with respect to the interest rate, since if investment is quite inelastic, neither policy will have much of an impact on investment.

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