© 2013 Pearson
Finance, Saving, and
Investment
26
CHECKPOINTS
© 2013 Pearson
Click on the button to go to the problem
Checkpoint 26.1
Checkpoint 26.2
Checkpoint 26.3
Problem 1
Problem 1
Problem 2
Problem 2
In the news
Problem 3
Problem 3
In the news
In the news
© 2013 Pearson
Problem 1
Clicker
version
Problem 2
CHECKPOINT 26.1
Practice Problem 1
Michael is an Internet service provider. On December 31,
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.
What was Michael’s gross investment, depreciation, and net
investment during 2012 and what is Michael’s capital at the
end of 2012?
© 2013 Pearson
CHECKPOINT 26.1
Solution
Michael’s gross investment during 2012 was $500,000—the
market value of the new servers he bought.
Michael’s depreciation during 2012 was $100,000—the fall
in the market value of some of his older servers.
Michael’s net investment during 2012 was $400,000.
Net investment equals gross investment minus
depreciation, which is ($500,000  $100,000).
© 2013 Pearson
CHECKPOINT 26.1
The capital grew during 2012 by the amount of net
investment.
Michael’s net investment during 2012 was $400,000.
So that at the end of 2012, capital was
$400,000 + $400,000, which equals $800,000.
© 2013 Pearson
CHECKPOINT 26.1
Practice Problem 2
Lori earns $20,000 after paying her taxes.
At the beginning of 2011, Lori owned $1,000 worth of
books, CDs, and golf clubs and she had $5,000 in a
savings account at the bank.
During 2011, the interest on her savings account was $300
and she spent $15,300 on consumption goods.
The market values of her books, CDs, and golf clubs did not
change.
How much did Lori save in 2011? What was her wealth at
the end of 2011?
© 2013 Pearson
CHECKPOINT 26.1
Solution
Lori saved $5,000.
Saving equals income (after tax) minus the amount
spent.
That is, Lori’s saving equaled $20,300 minus $15,300,
which is $5,000.
Lori’s wealth at the end of 2011 was $11,000—the sum
of her wealth at the start of 2011 ($6,000) plus her
saving during 2011 ($5,000).
© 2013 Pearson
CHECKPOINT 26.1
In the news
IMF urges EU banks to raise capital
The G-20 aims to take stock of the economic recovery.
One achievement in Pittsburgh could be a deal to require
that financial institutions hold more capital.
Source: USA Today, September 24, 2009
What are the financial institutions that the IMF urges to
raise more capital?
What exactly is the “capital” referred to in the news clip?
How might raising more capital make financial institutions
safer?
© 2013 Pearson
CHECKPOINT 26.1
Solution
The institutions are some European banks.
“Capital” in the news clip is the banks’ own funds.
By using more of its own funds and less borrowed funds,
a financial institution decreases its risk of insolvency in
the event that its assets lose value.
© 2013 Pearson
CHECKPOINT 26.2
Practice Problem 1
First Call, Inc. is a cellular phone company.
It plans to build an assembly plant that costs $10 million if
the real interest rate is 6 percent a year.
If the real interest rate is 5 percent a year, First Call will
build a larger plant that costs $12 million.
And if the real interest rate is 7 percent a year, First Call will
build a smaller plant that costs $8 million.
Draw a graph of First Call’s demand for loanable funds
curve.
© 2013 Pearson
CHECKPOINT 26.2
Solution
The demand for loanable
funds curve is the blue
downward-sloping curve
DLF0 and passes through the
points highlighted in the
figure.
© 2013 Pearson
CHECKPOINT 26.2
Practice Problem 2
First Call, Inc. is a cellular phone
company. The graph shows its
demand for loanable funds.
First Call expects its profit 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.
© 2013 Pearson
CHECKPOINT 26.2
Solution
An increase in the expected
profit increases investment
today, which increases the
quantity of loanable funds
demanded at each real
interest rate.
The demand for loanable
funds curve shifts rightward
to DLF1 in the figure.
© 2013 Pearson
CHECKPOINT 26.2
Study Plan Problem
First Call, Inc. expects its profit to double next year. If
other things remain the same, First Call _________.
A. increases the quantity of funds demanded along its
demand for loanable curve.
B. decreases its demand for loanable funds
C. increases its demand for loanable funds
D. decreases the quantity of funds demanded along its
demand for loanable curve
© 2013 Pearson
CHECKPOINT 26.2
Practice Problem 3
Draw a graph that illustrates 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.
© 2013 Pearson
CHECKPOINT 26.2
Solution
The increase in the supply of
loanable funds shifts the supply
curve rightward.
The decrease in the demand for
loanable funds shifts the demand
curve leftward.
The real interest rate falls.
If the shifts are of the same
magnitude, the equilibrium
quantity of funds remains
unchanged.
© 2013 Pearson
CHECKPOINT 26.2
In the news
Poof! How home loans transform
Banks make a profit by transforming home loans into
mortgage-backed securities and trading them on financial
loans markets. Banks then use this profit to issue more
home loans. During the credit crisis, the market for
mortgage-backed securities issued by banks almost
stopped functioning.
Source: The New York Times, September 18, 2009
Explain why the market for mortgage-backed securities
almost stopped functioning during the credit crisis of
2007–2008.
© 2013 Pearson
CHECKPOINT 26.2
Solution
The banks that create and sell mortgage-backed
securities demand loanable funds and the banks that buy
these securities supply loanable funds.
When home prices started to fall and home owners
defaulted, banks made fewer home loans and the
demand for mortgage-backed securities decreased.
These securities also became riskier, so the supply of
loanable funds to buy them dried up.
© 2013 Pearson
CHECKPOINT 26.3
Practice Problem 1
The table shows the demand for
loanable funds schedule and the
private supply of loanable funds
schedule.
If the government budget surplus
is $1 trillion, what are the real
interest rate, the quantity of
investment, and the quantity of
private saving?
© 2013 Pearson
CHECKPOINT 26.3
Solution
With a government budget
surplus of $1 trillion, the supply
of loanable funds curve is SLF.
The equilibrium real interest rate
falls from 7 percent to 6 percent
a year and the quantity of
loanable funds increases to
$2.5 trillion.
Investment is $2.5 trillion and
private saving is $1.5 trillion.
© 2013 Pearson
CHECKPOINT 26.3
Practice Problem 2
The table shows the demand for
loanable funds schedule and the
private supply of loanable funds
schedule.
If the government budget deficit
is $1 trillion, what are the real
interest rate, the quantity of
investment, and the quantity of
private saving?
Is there any crowding out?
© 2013 Pearson
CHECKPOINT 26.3
Solution
With a government budget
deficit
of $1 trillion, the demand for
loanable funds curve is DLF.
The real interest rate rises from
7 percent to 8 percent a year,
the quantity of loanable funds
increases to $2.5 trillion.
© 2013 Pearson
CHECKPOINT 26.3
Investment on the PDLF curve
decreases to $1.5 trillion.
Crowding out occurs because
the deficit raises the real
interest rate, which decreases
investment.
© 2013 Pearson
CHECKPOINT 26.3
Practice Problem 3
The table shows the demand
for loanable funds schedule
and the private supply of
loanable funds schedule.
If the government budget deficit
is $1 trillion and the RicardoBarro effect occurs, what are
the real interest rate and the
quantity of investment?
© 2013 Pearson
CHECKPOINT 26.3
Solution
If the Ricardo-Barro effect
occurs, private saving adjusts
to offset the budget deficit if $1
trillion.
The supply of loanable funds
increases by $1 trillion and the
equilibrium interest rate
remains at 7 percent a year.
© 2013 Pearson
CHECKPOINT 26.3
The quantity of loanable funds
is $3 trillion and it finances
investment of $2 trillion and the
budget deficit of $1 trillion.
Crowding out does not occur
because the real interest rate
does not change.
© 2013 Pearson
CHECKPOINT 26.3
In the news
Budget vote surprises GOP leaders
A group of lawmakers joined to defeat a bill to fund a
federal government deficit of $1,043 trillion for 2012.
Source: The Wall Street Journal, September 22, 2011
Explain the effect of a large federal deficit and debt on
economic growth.
© 2013 Pearson
CHECKPOINT 26.3
Solution
Compared to a balanced budget, a large federal
government deficit and debt increase the demand for
loanable funds.
The real interest rate rises and private investment
decreases.
Investment increases the capital stock and increases labor
productivity, the engine of growth.
The higher real interest rate slows the growth of the capital
stock, slows labor productivity growth, and slows real GDP
growth.
© 2013 Pearson