Activator Chapter 26
1.
2.
What would be the disadvantage of
putting your savings under your
mattress?
List some places that you could invest
your money that might cause it to gain
interest/grow.
Interest Rates
 Interest Rates – cost of credit for
borrowers, gains incurred from
lending
 Low interest rates
 Good for borrowers - people
buying a house, car, starting a
business, etc.
 Interest sensitive investments
 Bad for savers – low interest rates
amounts to low returns on
investments
 People hoping to earn interest on
saved money
 High interest rates
 Bad for borrowers – cost of credit
increases, making interest saving
investments less desirable
 Good for savers – high interest
rates amount to high returns on
investment
Calculators
 http://cgi.money.cnn.com/tools/mortgagecalc/
 http://www.moneychimp.com/calculator/compound_inter
est_calculator.htm
Chapter 26 – Saving, Investment, and the
Financial System
 Financial System – group of institutions that turn
savings into investments
 Financial Markets – institutions through which
savers can directly provide funds to borrowers.
Saving, Investment, and the Financial System
 Saving – the absence of spending;
income not spent, or deferred
consumption
 Bank, IRA, stocks, bonds, 401K,
pension, annuity, etc.
 Savings – dollars that become available
to borrowers/investors
 Loanable Funds - a hypothetical market
that brings savers and borrowers
together.
 Brings together the money available in
commercial banks and lending
institutions for firms and households to
finance expenditures, either investments
or consumption
 Savers supply, borrowers demand
Financial Institutions in the U.S. Economy
 The Bond Market
 Bond – IOU, certificate of indebtedness





that specifies the obligations of the
borrower to the holder of the bond
 Corporate, municipal, U.S. Federal
Debt finance – sale of bonds to raise
money, which is a debt to the lender
Principal – initial amount borrowed,
$1000
Date of maturity – time at which the loan
will be repaid, 10-2030
Term – length of time until the bond
matures, 30 years
Interest – rate at which the bond will be
repaid, 6%
Financial Institutions in the U.S. Economy
 The Bond Market
 Credit risk – the level of risk or loss by an





investor arising from a borrower that
potentially does not pay some interest or
principal
Junk bonds – bonds offered by shaky,
high-risk corporations
Default – failure to repay a borrowed loan
Tax treatment – the way tax laws treat
the interest earned on bonds
 The interest on most bonds is
considered taxable income
Municipal bonds – bonds offered by local
or state government
Federal bonds – bonds offered by the
U.S. Government. U.S. treasury
What is a bond video
 http://www.youtube.com/watch?v=svOsKnWlW-g
Financial Institutions in the U.S. Economy
 The Stock Market
 Stock – partial ownership of a firm
through the purchase of a share
 Claim to a portion of the profit the
firm generates
 Disney, Microsoft, Toys ‘R’ Us,
etc.
 Equity finance – sale of stocks to
raise money; a right to portions of
the profit of the company
Financial Institutions in the U.S. Economy
 The Stock Market
 Difference between Stocks and
Bonds:
 Owner of shares in a company
are a part owner of the company
 Owner of bonds are a creditor of
the company/institution
 Stockholders enjoy benefits of
profits while bondholders receive
interest on their bonds
 Bondholders are paid what they
are due before stockholders if the
company is in financial difficulty
 Stocks have a higher risk than
bonds, but a potentially higher
return
What is a stock video
http://www.youtube.com/watch?v=JrGp4ofULzQ

Stock
Exchanges
Stock Exchanges – places where buyers and
sellers meet to trade stocks
 Perfectly competitive market – identical
products, prices are based solely on
perception and speculation, supply and
demand
 Primary Market - newly issued IPO will be
considered a primary market trade when
the shares are first purchased by investors
directly
 Secondary market - also called aftermarket,
is the financial market in which previously
issued financial instruments such as stocks
and bonds are bought and sold
 New York Stock Exchange (NYSE) - a stock
exchange located at 11 Wall Street in lower
Manhattan, New York City, USA.
 It is the world's largest stock exchange
Stock Exchanges
 National Association of Securities
Dealers Automated Quotation System
(NASDAQ) - the largest electronic
screen-based equity securities trading
market in the United States
 Stock Index – computed average of a
group of stock prices
 Dow Jones Industrial Average,
Standard & Poor’s 500
 Bidding system – brokers bid up the
price of a share of stock through
demand for shares
 Price of shares based on the
following:
 Supply and Demand
 Perception of the company’s
profitability
 Profits and losses
Financial Intermediaries
 Financial Intermediaries – entity that channel funds from people who
have extra money (savers) to those who do not have enough money to
carry out a desired activity (borrowers).
 Banks – takes deposits from savers and loan to borrowers
 Mutual Funds – sell shares, pools money from investors into a portfolio
of investments (stocks, bonds, commodities, etc.)
Saving & Investment in National Income Accounts
 Gross domestic product (GDP)
 Total income = Total expenditure
 Y = C + I + G + NX
 Y= gross domestic product GDP
 C = consumption
 I = investment
 G = government
 NX = net exports
Consumption
Investment
Government
Net Exports
Saving & Investment in National Income Accounts
 Closed economy – one that does not interact with other
economies
 NX = 0
Y = C + I + G
Saving & Investment in National Income Accounts
 National saving (saving), S – total income in the economy that
remains after paying for consumption and government purchases
Saving & Investment in National Income Accounts
 Private saving –income that
households have left after paying for
taxes and consumption
 Public saving – tax revenue that the
government has left after paying for
its spending
Saving & Investment in National Income Accounts
 Budget surplus – income in excess of tax revenue over government spending; occurs
when the government takes in more than it spends
 T–G>0
 Budget deficit – shortfall of tax revenue from government spending; occurs when the
government spends more than it takes in
 T–G<0
 Crowding out - occurring when government borrowing to fund a deficit causes interest
rates to rise, thereby reducing investment spending.
 Increase in government spending crowds out investment spending.
Budget Deficit
Budget Deficits and the National Debt
Supply and Demand
The Market for Loanable Funds
 Market for loanable funds – market
for those who supply the funds and
those who borrow to invest
 Loanable funds – all income people
have chosen to save and lend out
rather than use for consumption
 Assumes a closed economy and only




one market for loanable funds
Market for loanable funds is governed
by supply and demand
Source of the supply of loanable funds
is savings (CIG)
Source of the demand for loanable
funds is spending (CIG)
Price of a loan = real interest rate
 Borrowers pay for a loan
 Lenders receive a return on their saving
The Market for Loanable Funds
 Supply and demand of loanable funds
 Demand curve – slopes downward
 As interest rate rises quantity demanded declines
 Supply curve - slopes upward
 As interest rate rises quantity supplied increases
supply
curve
The Market for Loanable Funds
 Shifts in the Demand Curve (buyers demand for money)
 Not a result of interest rates!
 Spending Incentives/Disincentives:
Consumption
 Tax credits where government gives consumers
more incentive to purchase (increase demand)
2. Investment
 Government gives tax credits to firms (increase
demand)
3. Government deficits
 Government lacks funds (increase
demand/decrease supply)
1.

The Market for Loanable Funds
Supply Curve (savers supply money)
 Not a result of interest rates!
 Saving Incentives/Disincentives:
1.
Consumption
 People become more thrifty
 A recession causes people to spend less and save more
 Laws that encourage saving
 Reduced taxes on financial investments (income)
2. Government deficits
 Government lacks the funds to pay the budget
The Loanable Funds Model
Real
Interest
Rate
Supply (S)
ir
Demand (D)
Qlf
0
Loanable Funds
•The interest rate in the economy adjusts to balance the supply and demand for
loanable funds.
•The supply of loanable funds comes from national saving, including both private saving
and public saving.
•The demand for loanable funds comes from firms, households and government that
want to borrow.
•The equilibrium interest rate is labeled ir, and quantity of loanable funds are supplied
and demanded qlf.
Daily Assignment – Loanable Funds Graphing
 Using a properly labeled graph, illustrate each
of the following scenarios:
1. Suppose the economy is in a recession and
the demand for loanable funds decreases.
2. Suppose the economy is in a recession and
the government injects funds into the
market.
3. Suppose the government implements a tax
credit for consumers in the housing market
which stimulates demand.
4. Suppose the government runs a budget
deficit and increases their reliance on
loanable funds (closed economy).
The Loanable Funds Model
Interest
Rate
S
ir1
ir2
D2
0
1.
Q2
Q1
D1
Loanable Funds
Suppose the economy is in a recession and the demand for loanable funds
decreases.
The Loanable Funds Model
Interest
Rate
S1
S2
ir1
ir2
D1
0
2.
Q1 Q2
Loanable Funds
Suppose the economy is in a recession and the government injects funds
into the market.
The Loanable Funds Model
Interest
Rate
S
ir2
ir1
D1
0
3.
Q1
Q2
D2
Loanable Funds
Suppose the government implements a tax credit for consumers in the
housing market which stimulates demand.
The Loanable Funds Model
Interest
Rate
S2
S1
ir2
ir1
D1
0
4.
Q2
Q1
Loanable Funds
Suppose the government runs a budget deficit and increases their reliance
on loanable funds (closed economy).
The Loanable Funds Model
Interest
Rate
S
ir2
ir1
D1
0
4.
Q1
D2
Loanable Funds
Suppose the government runs a budget deficit and increases their reliance
on loanable funds (closed economy).
Chapter 26 Homework, pgs. 586 - 593
Answer the following questions based on the reading:
1. How do American families compare to other countries when it comes to saving?
2. What principles of economics relate to Americans' saving habits.
3. How does the U.S. federal government discourage saving?
4. Describe the example provided in the book regarding a 25 year old investing in a
bond.
5. What example is provided as a way to improve saving in the U.S.?
6. What curve would this policy affect; Which way would the curve shift?
7. How would this affect both the quantity of loanable funds and the interest rates?
8. What does an investment tax credit refer to?
9. Which curve would it affect; which way would it shift?
10. How would an investment tax credit affect the interest rate and the loanable funds?
11. How does a budget deficit affect the supply for loanable funds; which way does the
curve shift?
12. What does crowding out refer to?
13. Why does increased borrowing by the government shift the supply curve and not the
demand curve?
14. Describe what a declining debt-GDP ratio , and a rising debt-GDP ratio indicates as it
relates to indebtedness.
15. How does war affect the debt to GDP ratio?
16. Describe the two reasons that debt financing is an appropriate policy.
17. How was government debt affected as a result of the Ronald Reagan administration?
18. What was a primary goal of the Clinton administration?
Chapter 26 Homework, pgs. 586 - 593
Answer the following questions based on the reading:
1. How do American families compare to other countries
when it comes to saving?
2. What principles of economics relate to Americans'
saving habits.
3. How does the U.S. federal government discourage
saving?
4. Describe the example provided in the book regarding a
25 year old investing in a bond.
5. What example is provided as a way to improve saving in
the U.S.?
6. What curve would this policy affect; Which way would
the curve shift?
7. How would this affect both the quantity of loanable funds
and the interest rates?
8. What does an investment tax credit refer to?
9. Which curve would it affect; which way would it shift?
10. How would an investment tax credit affect the interest
rate and the loanable funds?
11. How does a budget deficit affect the supply for loanable
funds; which way does the curve shift?
12. What does crowding out refer to?
13. Why does increased borrowing by the government shift
the supply curve and not the demand curve?
14. Describe what a declining debt-GDP ratio , and a rising
debt-GDP ratio indicates as it relates to indebtedness.
15. How does war affect the debt to GDP ratio?
16. Describe the two reasons that debt financing is an
appropriate policy.
17. How was government debt affected as a result of
the Ronald Reagan administration?
18. What was a primary goal of the Clinton administration?
1. Am. Families save a smaller fraction of their incomes than other
countries.
2. Standard of living depends on its ability to produce. People
respond to incentives.
3. Taxes placed upon interest and dividends.
4. 30 year $1000 bond at 9% interest = $13268. Taxes of 33%, real
interest rate = 6%. Growth of only $5,743.
5. Expand eligibility for IRAs, which shelter taxes.
6. Supply curve, shift to the right.
7. Increase the quantity of loanable funds, dropping the interest
rate.
8. Tax advantage to any firm that builds a new factory or buys a
new piece of equipment.
9. Demand curve, shift to the right.
10. Interest rates would increase and increase the quantity supplied
of loanable funds.
11. Reduces the amount of loanable funds because the government
reduces its supply of loanable funds. Shifts the supply curve to
the left.
12. A decrease in investment that results from government borrowing
and budget deficits.
13. Budget deficit reduces supply of loanable funds, thus affecting
the supply not demand of loanable funds.
14. Declining debt-GDP ratio indicates government indebtedness is
shrinking relative to its ability to raise tax revenue. Rising debtGDP ratio, government indebtedness is increasing relative to its
ability to raise tax revenue.
15. Government spending increases and budget deficit increases,
increasing debt to GDP ratio
16. Allows the government to keep stable tax policy. Shifts part of the
burden to future generations.
17. Smaller government and lower taxes, but increased budget
deficits and borrowing.
18. Clinton balanced the budget and eventually ran a budget surplus.
Review Questions – Chapter 26
1. Draw a properly labeled loanable funds market model.
Interest
Rate
Supply (Slf)
ir
Demand (Dlf)
0
Qlf
Quantity of Loanable Funds
2. a. Supply curve represents the supply of loanable funds in the
marketplace.
b. Demand represents the demand for loanable funds in the
marketplace.
3. Interest rates go up suppliers want to provide more loans. Interest
rates go down, investors will have an incentive to borrow. Vice versa.
4. Using a correctly labeled graph of the loanable funds market, show how
a decision to increase saving for retirement will affect the real market
interest rate in the short run. Explain your answer in words and a
graph.
Word Explanation – If the supply of loanable funds increases, this will
drive down the real interest rate in the market for loanable funds.
5.
a. Long term, because it is more likely that you may need to sell the long-term
bond at a depressed price prior to maturity.
b. Yes, the credit risk has increased and lenders would demand a higher rate of
return.
c. Owners of shares demand a higher rate of return because it is riskier.
d. It is safer to put money in an investment fund because it is diversified (not all of
your eggs are in one basket).
6.
a.
b.
c.
d.
(6,000 – 1,000 – 4,000) + (1,000 – 1,200) = 800 billion
6,000 – 1,000 – 4,000 = 1,000 billion
1,000 – 1,200 = –200 billion
It is harming growth because public saving is negative so less is available for
investment.
7.
a. Equilibrium real interest rate = 4%, equilibrium S and I = 1000 billion.
b. At 2 per cent interest, the quantity demanded of loanable funds exceeds the
quantity supplied by 900 billion. This excess demand for loans (borrowing) will
drive interest rates up to 4 per cent.
8. Equilibrium real interest rate = 5%, equilibrium S and I = 800 billion.
9. Equilibrium real interest rate = 5%, equilibrium S and I = 1200 billion.
10. An investment tax credit, because it shifts the demand for loanable funds to
invest in capital to the right, raising the level of investment in capital and
stimulating growth.
http://articles.latimes.com/2010/sep/07/nation/la-na-obama-economy-20100907
http://marriage.about.com/od/finances/a/marriagepenalty.htm
2005 AP Macroeconomics Free-Response Questions
Binder Check Due Today
Chapter 25
1. Chapter 25 Mankiw
Practice Review
2. North Korea Video
3. Notes
4. Terms
Chapter 26
1. Free Response
2. Ch. 26 Mankiw Practice
Review
3. Notes
4. Daily Tens
5. Terms
Extra Credit
1. How does a high interest
rate affect savers and
borrowers?
2. How does a low interest
rate affect savers and
borrowers?
52
Rules of the game:
•Monopolies occur when a player acquires all of one property color or all of the utilities
1. Once a player has declared their monopoly to the government, a monopoly can charge any price
they wish for their properties (price discrimination may occur).
2. The government (Coach L) must be notified of any monopoly.
3. Other members of the market (other players) can voice complaints to the government regarding
unfair price increases or inconsistent monopoly practices.
4. Responses to complaints can include fines, restrictions on ability to operate for certain amounts of
time (ie: monopolies can only occur for two turns around the board), price ceilings or in extreme
cases, jailings or breaking up of monopolies.
•Oligopolies can form when a group of two or more players have all the properties of one color between
them.
1. As an oligopoly you can charge any price you wish for your properties; you ALL must agree on the
price.
2. Once you set the price, you may not change it until two rounds have passed.
•Loanable Funds Market:
1. You must determine a way to incorporate the principles of the loanable funds into your market.
2. Example:
1. The center of the board acts as the loanable funds market.
2. Each round you must alternate as a saver and a borrow.
3. Government policies state that you can save 10% of your gross income; you can borrow up to
30% of your income (saved money can be collected 3 rounds after it is saved, borrowed
money must be repaid + interest after 4 rounds from the time borrowed).
4. After each player has completed a round, the interest rate will be set based up on the
amount of loanable funds in the market (i.e. 200 – 10%, 300 – 8%, 500 – 5%, 1000 – 2%, etc.
5. One person should keep track of the loanable funds that are borrowed and saved each round
and payouts to players (this money should come from the loanable funds market or the
bank).