Chapter 8, Problem 7PA

Subpart (a):

To determine

The Investment and the loanable fund market of the economy.

Explanation of Solution

Investment is an asset or an item purchased today in the hope that it will generate income in the future. In that sense, the spending of capital on the purchase of new physical capitals refers to the equipment and the buildings and so forth.

When there is no possibility of loanable fund market between the students and each have to invest their own amounts, then each of the students will have the following returns after one year:

$\begin{array}{c}{\text{Returns}}_{\text{Harry}}=\text{Investment}\times \left(1+\text{Interest rate}\right)\\ =1,000\times \left(1+0.05\right)\\ =1,000\times 1.05\\ =1050\end{array}$

Thus, Harry will have $1,050 after one year. Similarly, the returns of Ron and Hermione can be calculated as follows:

$\begin{array}{c}{\text{Returns}}_{\text{Ron}}=\text{Investment}\times \left(1+\text{Interest rate}\right)\\ =1,000\times \left(1+0.08\right)\\ =1,000\times 1.08\\ =1080\end{array}$

Thus, Ron will have $1,080 after one year.

$\begin{array}{c}{\text{Returns}}_{\text{Hermione}}=\text{Investment}\times \left(1+\text{Interest rate}\right)\\ =1,000\times \left(1+0.20\right)\\ =1,000\times 1.20\\ =1200\end{array}$

Thus, Hermione will have $1,200 after one year.

Economics Concept Introduction

Concept introduction:

Investment: It is an asset or an item purchased today in the hope that it will generate income in the future.

Subpart (b):

To determine

The Investment and the loanable fund market of the economy.

Explanation of Solution

When there is a loanable fund market between the students at the rate of interest 'r', each student will compare the rate of their return with the rate of interest in the loanable fund market for loanable funds, which is 'r'. When the rate of returns is higher than the rate of interest, the student would borrow and if it is lower than the interest rate, then the student will lend.

Economics Concept Introduction

Concept introduction:

Investment: It is an asset or an item purchased today in the hope that it will generate income in the future.

Subpart (c):

To determine

The Investment and the loanable fund market of the economy.

Explanation of Solution

When the rate of interest is 7 percent, Harry would want to lend the money with him because when he compares the rate of return of 6 percent with the rate of interest, the rate of interest is higher. On the other hand, the rate of returns of Ron and Hermione is higher than the rate of interest of 7 percent and they both would like to borrow. So, the quantity of loanable funds demanded will be $2,000, while quantity of loanable funds supplied will be equal to $1,000.

When the rate of interest increases to 10 percent, both Harry and Ron would turn out to be lenders because their rate of return is lower than the rate of interest but Hermione would still be the borrower, since the rate of return is higher than the rate of interest. Here, the quantity of loanable funds demanded is $1,000 and quantity of loanable funds supplied is $2,000.

Economics Concept Introduction

Concept introduction:

Investment: It is an asset or an item purchased today in the hope that it will generate income in the future.

Subpart (d):

To determine

The Investment and the loanable fund market of the economy.

Explanation of Solution

The loanable fund market will be in equilibrium when the quantity of loanable funds demanded and supplied in the market becomes equal. At 8 percent rate of interest, Harry would like to lend and Hermione would like to borrow. Ron would use his own savings to invest because the rate of interest and rate of return to him is equal and he would not like to lend or borrow. Thus, the quantity of loanable fund supplied will become $1,000 by Harry and that which was demanded will also become $1,000 by Hermione. This would make the loanable fund market equilibrium and thus the quantity demanded and supplied in the loanable fund market will be $1,000.

Economics Concept Introduction

Concept introduction:

Investment: It is an asset or an item purchased today in the hope that it will generate income in the future.

Subpart (e):

To determine

The Investment and the loanable fund market of the economy.

Explanation of Solution

When the rate of interest in the economy is 8 percent, Ron will use his own capital stock and Harry would lend the amount with him. Thus, both of them will earn the same rate of return which is 8 percent. This can be calculated as follows:

$\begin{array}{c}{\text{Returns}}_{\text{Ron \& Harry}}=\text{Investment}\times \left(1+\text{Interest rate}\right)\\ =1,000\times \left(1+0.08\right)\\ =1,000\times 1.08\\ =1080\end{array}$

Thus, both of them would earn $1,080. So, the lender Harry would earn $30 higher than without lending a return to him. In the case of Hermione, he will borrow $1,000 from Harry and would invest but he has to repay the $1,000 and its 8 percent interest to Ron. Thus, the returns to Hermione can be calculated as follows:

$\begin{array}{c}{\text{Returns}}_{\text{Hermione}}=\left[\text{Investment}\times \left(1+\text{Interest rate}\right)\right]-\left[\text{Borrowed money}\times \left(1+\text{Interest rate}\right)\right]\\ =\left[2,000\times \left(1+0.20\right)\right]-\left[1,000\times \left(1+0.08\right)\right]\\ =\left(2,000\times 1.20\right)-\left(1,000\times 1.08\right)\\ =2400-1080\\ =1320\end{array}$

Thus, Hermione will have a return of $1,320 which is $120 higher than no loanable fund market. Thus, since the borrower and lender are better off in the economy, no one is worse off.

Economics Concept Introduction

Concept introduction:

Investment: It is an asset or an item purchased today in the hope that it will generate income in the future.