Chapt er 7 FINANCE, SAVING, AND...

© 2014 Pearson Education, Inc.

7 FINANCE, SAVING, AND INVESTMENT *

* This chapter is Chapter 24 in Economics.

K e y C o n c e p t s

Financial Institutions and Financial Markets

Finance and money are different: Finance refers to rais-ing the funds used for investment in physical capital and money refers to what is used to buy goods and services. Physical capital is the actual tools, instruments, ma-chines, buildings, and other items constructed in the past and used to produce goods and services. Financial capital is the funds firms use to buy and operate physi-cal capital. When economists say “capital” they mean physical capital.

Depreciation is the decrease in the capital stock be-cause of wear and tear and obsolescence. Gross in-vestment is the total amount spent on new capital. Net investment is the change in the value of the capital stock. Net investment equals gross invest-ment minus depreciation.

Wealth is the value of things that people own. Sav-ing is the amount of income not paid in taxes or spent on consumption of goods and services. Sav-ings adds to wealth.

Saving is a source of funds used for financial capital. Funds are demanded and supplied in three financial markets:

Loan markets—the market where firms and house-holds demand loans. Some loans are mortgages, a contract that gives ownership of a home to the lender in the event that the borrower fails to meet the agreed loan payments.

Bond markets—the market in which firms and gov-ernments borrow funds by issuing bonds. A bond is a promise to make specified payments on specified dates. Bonds issued by firms and governments are traded in the bond market. Another type of bond is a mortgage-backed security, which is a bond

that entitles its owner to the income from a package of mortgages. The income comes from the interest and principal payments made by homeowners on their mortgage.

Stock markets—a stock is a certificate of ownership and claim to the profits that a firm makes. A stock market is a financial market in which shares of cor-porations’ stocks are traded.

A financial institution is a firm that operates on both sides of the markets for financial capital; that is, it bor-rowers from savers and lends to borrowers. Financial institutions include commercial banks, government sponsored mortgage lenders, pension funds, and insur-ance companies.

A financial institution’s net worth is the total mar-ket value of what it has lent minus the market value of what it has borrowed. If net worth is positive, the business is solvent; if net worth is negative, the busi-ness is insolvent and must close. A firm is illiquid if it cannot meet demands to repay what it has bor-rowed to the people who have loaned to it.

Stocks, bonds, short-term securities, and loans are called financial assets. The interest rate on a financial asset is the amount paid divided by the price of the asset, then multiplied by 100. When the price of an asset rises, the interest rate on it falls.

The Loanable Funds Market

The loanable funds market is the aggregate of all the individual financial markets. The funds that finance investment—household saving, government budget surplus, and borrowing from the rest of the world—are obtained in the loanable funds market. Household saving is S; the government budget surplus is net taxes minus government expenditure, T G; and borrowing from the rest of the world is imports minus exports, M X. (If we import more than we export, we borrow from the rest of the world and if we export more than

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we import, we lend to the rest of the world.) In the form of an equation,

I = S + (T G) + (M X)

National saving is the sum of private saving and government saving, S + (T G). With this defini-tion, national saving and borrowing from abroad finance investment.

The nominal interest rate is the number of dollars a borrower pays and a lender receives in interest in a year expressed as a percentage of the loan; the real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money.

The real interest rate is (approximately) equal to the nominal interest rate minus the inflation rate.

Demand for Loanable Funds The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international invest-ment or lending. For now ignore the government budget deficit and international transactions to focus on investment. The quantity of loanable funds demanded for invest-ment depends on the real interest rate and the expected profit. The higher the real interest rate, the fewer in-vestment projects that are profitable.

The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same. Figure 7.1 shows a demand for loanable funds curve, DLF. A change in the real interest rate leads to a movement along the demand for loanable funds curve. A rise in the real interest rate decreases the investment projects firms undertake and thereby decreases the quantity of loanable funds demanded.

An increase in expected profit increases investment and shifts the demand for loanable funds curve rightward. Expected profit increases during a busi-ness cycle expansion, when technological change creates new profit opportunities, when a growing population increases the demand for goods and ser-vices, and when business executives are generally optimistic about the future. All these shift the de-mand for loanable funds curve rightward.

Supply of Loanable Funds The quantity of loanable funds supplied is the total funds available from private saving, the government budget

surplus, and international borrowing. For now ignore the government budget surplus and international trans-actions to focus on saving. The quantity of loanable funds supplied depends on the real interest rate, disposable income, expected fu-ture income, wealth, and default risk.

The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same. Figure 7.1 shows a supply of loanable funds curve, SLF. A change in the real interest rate leads to a movement along the supply of loanable funds curve. A rise in the real interest rate increases the quantity of saving.

An increase in disposable income, a decrease in expected future income, a decrease in wealth, or a decrease in default risk increase saving and shift the supply of saving curve rightward.

Equilibrium in the Loanable Funds Market The demand for loanable funds and the supply of loan-able funds determine the real interest rate. In Figure 7.1, the equilibrium real interest rate is 4 percent and the equilibrium quantity of loanable funds is $2.0 tril-lion.

If the demand for loanable funds increases, the demand curve shifts rightward. The real interest rate rises and the quantity of loanable funds increases.

If the supply of loanable funds increases, the supply curve shifts rightward. The real interest rate falls

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and the quantity of loanable funds decreases. In the United States, over time both the supply and demand of loanable funds have grown at similar rates so the quantity of loanable funds has increased and the real interest has not trended higher or lower.

Government in the Loanable Funds Market

A government budget surplus adds to private saving and is part of the supply of loanable funds. An increase in the government budget surplus increases the supply of loanable funds, which lowers the real interest rate and increases the quantity of loanable funds. A government budget deficit is part of the demand for loanable funds. An increase in the government budget deficit increases the demand for loanable, which raises the real interest rate and increases the quantity of loan-able funds. However the quantity of investment de-creases because of the higher real interest rate.

The tendency for a government budget deficit to raise the real interest and decrease investment is called the crowding-out effect.

The crowding-out effect can be offset by the Ricar-do-Barro effect. The Ricardo-Barro effect says that a government budget deficit means higher taxes in the future, so taxpayers increase their private saving to be able to pay the higher taxes. The increase in private saving offsets the decrease in government saving.

The Global Loanable Funds Market

The loanable funds market is global rather than con-fined inside a nation. The world real interest rate makes the world quantity of loanable funds demanded equal to the world quantity of loanable funds supplied. Because financial funds can flow from one nation to another, funds leave nations with low real interest rates to go to nations with high real interest rates.

If a country’s net exports are negative (X < M) the country borrows funds from the rest of the world. The country has a shortage of funds at the world re-al interest rate. When funds enter a country, the quantity of loanable funds there increases,

If a country’s net exports are positive (X > M) the country loans funds to the rest of the world. The country has a surplus of funds at the world real in-terest rate. When funds leave a country, the quanti-ty of loanable funds there decreases.

Figure 7.2 shows the situation for a country, such as the United States, in which net exports are negative and the country borrows from abroad. In the absence of international trade the real interest in the country would be 6 percent; with trade the real interest rate in the country equals the world real interest rate, 4 per-cent. At the world real interest rate of 4 percent, the country has negative net exports and net foreign bor-rowing of $1.5 trillion, the difference between the quantity of loanable funds demanded, $3.0 trillion, and the quantity of loanable funds supplied, $1.5 trillion.

H e l p f u l H i n t s

1. FINANCIAL INSTITUTIONS: Financial institutions are firms that operate in the nation’s financial mar-kets. Unlike other businesses, such as pizza parlors, for which it is easy to see what they do and how they benefit society, sometimes it is more difficult to understand what a financial institution does and how it benefits society. Think in terms of the loan-able funds model. In its simplest form, the supply of loanable funds is from peoples’ saving and the demand for loanable funds is from firms’ demand for capital, that is, investment demand. It would be incredibly difficult if people who wanted to save had to individually seek out firms who wanted to borrow. Financial institutions ease the process of matching savers with borrowers by taking the sav-ings of a large number of savers and making loans

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to large numbers of borrowers. Financial interme-diaries help set the quantity of loanable funds sup-plied equal to the quantity demanded. And by so doing, financial institutions benefit society by help-ing channel savings to borrowers.

2. THE SUPPLY AND DEMAND MODEL ONCE AGAIN: The loanable funds market works like the “typical” supply and demand markets you studied in Chap-ter 3. Everything you learned there about the sup-ply and demand model applies to this market, such as the equilibrium point is where the two curves cross. Also the key difference between shifts in a curve versus movements along a curve is still im-portant: changes in the real interest rate create movements along the demand for and supply of loanable funds curves while other relevant factors shift the curves.

Q u e s t i o n s

True/False and Explain


11. Money and capital are different names for the same thing.

12. Gross investment is larger than net investment.

13. The nation’s bond market is one of the markets for financial capital.

14. If a financial institution is illiquid, it is insolvent.

15. If the interest rate paid on an asset increases, the price of the asset also increases.


16. Investment is financed using only households’ sav-ings.

17. The real interest rate is the opportunity cost of investment.

18. An increase in the real interest rate increases the quantity of people’s saving.

19. An increase in expected profit shifts the supply of loanable funds curve rightward.

10. The equilibrium real interest rate sets the quantity of loanable funds demanded equal to the quantity of loanable funds supplied.

11. An increase in default risk raises the real interest rate.


12. A government budget surplus adds to the supply of loanable funds.

13. An increase in the government budget deficit low-ers the real interest rate.

14. The stronger the Ricardo-Barro effect, the greater the amount of crowding out.


15. When the world loanable funds market is in equi-librium, the loanable funds markets within each country also are in equilibrium so that no country borrows or lends to other countries.

16. If a country’s imports exceed its exports, the coun-try borrows from the rest of the world.

17. If the demand for loanable funds increases in a small country that is borrowing from the rest of the world, the country’s net foreign borrowing increases.

Multiple Choice


11. The funds used to buy and operate physical capital are a. depreciation. b. financial capital. c. saving. d. wealth.

12. This year Pizza Hut makes a total investment of $1 billion in new stores. Its depreciation in this year is $300 million. Pizza Hut’s gross investment is ____ and its net investment is ____. a. $1 billion; $1 billion b. $1 billion; $300 million c. $1.3 billion; unknown d. $1 billion; $700 million

13. An individual’s wealth at the end of the year equals the person’s wealth at the beginning of the year a. plus saving and minus depreciation. b. minus depreciation. c. plus saving. d. minus saving plus depreciation.



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14. If a bank’s net worth is negative, then the bank defi-nitely is a. liquid. b. illiquid. c. solvent. d. insolvent.

15. If the interest rate on an asset falls, the price of the asset a. rises. b. does not change. c. falls. d. None of the above because there is no consistent

relationship between the interest rate on an asset and its price.


16. Which of the following is NOT a source of funds that can help finance a nation’s investment? a. households’ saving b. government budget surplus c. consumption expenditure d. borrowing from the rest of the world

17. An increase in the real interest rate ____ the de-mand for loanable funds curve. a. results in a movement along b. results in a rightward shift of c. results in a leftward shift of d. has no effect on

18. Expected profit rises a. when the real interest rate falls. b. during business cycle recessions. c. when sales fall so that the company has time to

make investments. d. when technology advances make firms optimistic

about future profits.

19. Which of the following increases the demand for loanable funds? a. an increase in disposable income b. an increase in expected future income c. an increase in default risk d. an increase in expected profit

10. Which of the following increases the supply of loan-able funds? a. an increase in disposable income b. an increase in expected future income c. an increase in default risk d. an increase in expected profit

11. An increase in disposable income shifts the ____. a. demand for loanable funds curve rightward b. demand for loanable funds curve leftward c. supply of loanable funds curve leftward d. supply of loanable funds curve rightward

12. If the real interest rate is less than the equilibrium real interest rate, the quantity of loanable funds sup-plied is ____ than the quantity of loanable funds demanded and the real interest rate ____. a. greater; rises b. greater; falls c. less; rises d. less; falls

13. An increase in disposable income ____ the equilib-rium real interest rate and ____ equilibrium quanti-ty of loanable funds. a. raises; increases b. raises; decreases c. lowers; increases d. lowers; decreases

14. If the expected profit falls, as a result the equilibrium real interest rate ____ and the equilibrium quantity of loanable funds ____. a. rises; increases b. rises; decreases c. falls; increases d. falls; decreases


15. An increase in the government budget deficit in-creases the ____ loanable funds and an increase in the government budget surplus increases the ____ loanable funds. a. demand for; demand for b. demand for; supply of c. supply of; demand for d. supply of; supply of

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16. An increase in the government budget surplus ____ the equilibrium real interest rate and ____ the equi-librium quantity of loanable funds. a. raises; increases b. raises; decreases c. lowers; increases d. lowers; decreases

17. An increase in the government budget deficit ____ the equilibrium real interest rate and ____ the equi-librium quantity of loanable funds. a. raises; increases. b. raises; decreases c. lowers; increases d. lowers; decreases

18. Crowding out refers to the decrease in a. government expenditure that results when the

demand for loanable funds increases. b. investment from the rise in the real interest rate

that results from a government budget deficit. c. investment from the rise in the real interest rate

that results from a government budget surplus. d. loanable funds that results when the real interest

rate rises.


19. When the global loanable funds market is in equilib-rium, then the real interest rate is a. higher in large countries. b. lower in large countries. c. equal in all countries. d. equal in all countries after adjusting for risk.

20. A small country is a net foreign lender and its supply of loanable funds increases. As a result, the equilib-rium quantity of loanable funds used in the country ____ and the country’s foreign lending ____. a. increases; decreases b. increases; does not change c. does not change; increases d. increases; increases

21. If the world real interest rate rises, then a country that is a net foreign lender a. increases the amount of its lending. b. does not change the amount of its lending. c. decreases the amount of its lending. d. None of the above answers is correct because

lending might increase, decrease, or not change.

Short Answer Problems

1. What is the relationship between investment and capital? Between saving and wealth?

2. Of the two, a bond and a stock, which is a certifi-cate of ownership?

3. For a financial institution, what is the difference between insolvency and illiquidity? Can a firm be solvent and illiquid? Insolvent and liquid?

T A B L E 7 . 1

Short Answer Question 4

Price of the asset (dollars)

Amount paid on the asset (dollars)

Interest rate on the asset (percent)

200 2 ____

100 2 ____

____ 50 5.0

____ 50 10.0

4. Complete Table 7.1 showing the relationship be-tween the price of an asset, the amount paid on the asset, and the asset’s interest rate.

5. What are the sources that supply loanable funds? What are the sources that demand loanable funds?

T A B L E 7 . 2

Demand and Supply Schedules

Real interest rate

(percent)

Quantity of loanable funds demanded

(trillions of dollars)

Quantity of loanablefunds supplied

(trillions of dollars)

1.0 1.4 0.8

2.0 1.3 1.0

3.0 1.2 1.2

4.0 1.1 1.3

5.0 1.0 1.4

6. a. Table 7.2 presents the demand for loanable funds and the supply of loanable funds sched-ules. Graph these demand and supply schedules in Figure 7.3 (on the next page). What is the equilibrium real interest rate? The equilibrium quantity of loanable funds?

b. If the demand for investment increases by $0.2 trillion at every interest rate, show the effect in Figure 7.3. What is the real interest rate and quantity of loanable funds?



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c. After the increase in demand, suppose the sup-

ply of loanable funds also increases by $0.2 bil-lion. Show the effect in Figure 7.3. What now is the real interest rate and quantity of loanable funds?

7. a. Figure 7.4 shows the loanable funds market. What is the equilibrium real interest rate and quantity of loanable funds?

b. Suppose the government budget deficit increases by $0.4 trillion. Show the effect of this increase in Figure 7.4 What is the new equilibrium real

interest rate and quantity of loanable funds?

How much investment has been crowded out?

8. a. Figure 7.5 shows the loanable funds market in Katiana, a small economy to the South. If the world real interest rate is 3 percent, what is the quantity of loanable funds in Katiana? Is Katia-na a net borrower or lender? How much does the country borrow or lend?

b. In Figure 7.5, suppose the world real interest rate rises to 4 percent. Now what is the quantity of loanable funds in Katiana? Is Katiana now a net borrower or lender? How much does Katiana now borrow or lend?

9. Suppose that a small country is net foreign borrow-er. If the government budget deficit in the country increases and there is no Ricardo-Barro effect, ex-plain what happens to the country’s foreign bor-rowing.

You’re the Teacher

1. “I really don’t understand one thing about this chapter: Why does investment decrease when the real interest rate rises? I just don’t get this! After all, if I could get more interest, I’d sure invest more in my savings account at my bank!” Your friend is making a fundamental error. Correct it and per-haps you can earn your friend’s undying gratitude ... or your friend’s help in another course you’re both taking!

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A n s w e r s

True/False Answers


11. F Capital refers to factories, assembly lines, and so forth; money refers to what is used to buy goods and services.

12. T Net investment equals gross investment minus depreciation.

13. T The loan markets and the stock markets also are part of the nation’s financial capital markets.

14. F A financial firm can be illiquid but be solvent.

15. F There is an inverse relationship between the in-terest rate and the price of an asset: if the interest rate increases, the price decreases.


16. F A government budget surplus as well as borrow-ing from abroad also can be used to finance in-vestment.

17. T Because the real interest rate is the opportunity cost of investment, an increase in the real inter-est rate decreases the quantity of investment.

18. T As the real interest rate rises, the “reward” from saving increases, so people increase the amount they save.

19. F An increase in expected profit increases invest-ment and shifts the demand for loanable funds curve rightward; it does not shift the supply of loanable funds curve.

10. T At the equilibrium real interest rate, there is neither a shortage nor a surplus of loanable funds.

11. T The increase in default risk decreases the supply of loanable funds which raises the real interest rate.


12. T A government budget surplus increases the sup-ply of loanable funds within the country.

13. F An increase in the government budget deficit increases the demand for loanable funds and raises the real interest rate.

14. F The Ricardo-Barro effect concludes that changes in the budget deficit have no effect on the real interest rate or investment.


15. F When the world loanable funds market is in equilibrium, individual countries still borrow and lend among themselves.

16. T If imports exceed exports, net exports are nega-tive and the country borrows from the rest of the world.

17. T When the demand for loanable funds increases, the increase in demand is met by foreign bor-rowing.

Multiple Choice Answers


11. b Financial capital are the funds a company needs to buy and operate its physical capital.

12. d Gross investment is the total amount of invest-ment; net investment is gross investment minus depreciation.

13. c Saving adds to wealth.

14. d Insolvency occurs when a financial firm’s market value of what it has lent is less than the market value of what it has borrowed.

15. a There is an inverse relationship between the price of an asset and the asset’s interest rate.


16. c The funds that finance a nation’s investment equals the sum of households’ saving, govern-ment budget surplus, and borrowing from abroad.

17. a An increase in the real interest rate decreases investment and creates a movement along the demand for loanable funds curve.

18. d When firms become more optimistic about ex-pected profit then more investment projects are undertaken.

19. d An increase in expected profit raises the demand for investment, which increases the demand for loanable funds.

10. a An increase in disposable income increases households’ saving, which increases the supply of loanable funds.

11. d Because the increase in disposable income in-creases the supply of loanable funds, the supply of loanable funds curve shifts rightward.

12. c The quantity of loanable funds supplied is less



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than the quantity of loanable funds demanded, which forces the real interest rate to rise toward its equilibrium.

13. c The supply of loanable funds curve shifts right-ward so the real interest rate falls and the quanti-ty of loanable funds increases.

14. d The demand for loanable funds curve shifts leftward so the real interest rate falls and the quantity of loanable funds decreases.


15. b A government budget deficit increases the de-mand for loanable funds and a government budget surplus increases the supply of loanable funds.

16. c The increase in the government budget surplus increases the supply of loanable funds, which lowers the real interest rate and increases the quantity of loanable funds.

17. a The increase in the government budget deficit increases the demand for loanable funds, which raises the real interest rate and increases the quantity of loanable funds.

18. b The answer is essentially the definition of “crowding out.”


19. d When the global loanable funds market is in equilibrium, the only reason real interest rates differ in nations is due to a difference in risk.

20. c The demand for loanable funds does not change, so the quantity of loanable funds in the nation does not change. The increase in the supply of loanable funds increases the quantity of loans the country makes to the rest of the world.

21. a A rise in the real interest rate decreases the quan-tity of loanable funds demanded and increases the quantity of loanable funds supplied, so the country has more funds to lend abroad.

Answers to Short Answer Problems

1. In general, investment adds to capital. In particular, net investment is the change in the capital stock from one period to the next. Saving adds to wealth.

2. A share of stock is a certificate of ownership. If you own a share of Microsoft stock, you are a partial owner of Microsoft. A bond is a debt because it is a

promise to make payments at specified periods in time. If you own a bond issued by Microsoft, you have essentially made a loan to Microsoft.

3. A financial institution is insolvent if the total mar-ket value of what it has lent, that is, the assets it owns, exceeds the total market value of what it has borrowed, that is, the debts it owes. A firm is illiq-uid if it cannot meet demands for repayment from the people that have made loans to it. A financial firm can be solvent and illiquid. Typically this situa-tion occurs when many lenders to the firm suddenly demand repayment. A financial firm also can be in-solvent and liquid. In this case the firm can meet in-itial demands for repayment but eventually the firm will be unable to do so because the market value of what it has borrowed exceeds the market value of what it has lent.

T A B L E 7 . 3

Short Answer Question 4

Price of the asset (dollars)

Amount paid on the asset (dollars)

Interest rate onthe asset (percent)

200 2 1.0

100 2 2.0

1,000 50 5.0

500 50 10.0

4. The completed table is above. The interest rate paid on the asset equals the amount paid on the as-set divided by the price of the asset and then mul-tiplied by 100. The table shows the inverse relationship between the price of the asset and the interest rate: when the interest rate rises, the price falls and when the interest rate falls, the price rises.

5. The sources that supply loanable funds are house-holds’ saving, a government budget surplus, and borrowing from the rest of the world. The sources that demand loanable funds are firms’ investment, a government budget deficit, and loaning to the rest of the world.

6. a. Figure 7.6 (on the next page) shows the demand for loanable funds curve, DLF0 and the supply of loanable funds curve, SLF0. The equilibrium real interest rate is 3 percent and the equilibrium quantity of loanable funds is $1.2 trillion.

b. If the demand for investment increases by $0.2 trillion at every interest rate, in Figure 7.6 the

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demand for loanable funds curve shifts rightward

to DLF1. The real interest rate rises to 4 percent and the quantity of loanable funds increases to $1.3 trillion.

c. After the increase in supply, the supply of loana-ble funds curves shifts rightward SLF1. The real interest rate returns to 3 percent and the quanti-ty of loanable funds increases to $1.4 trillion. Similar sized increases in the demand for loana-ble funds and the supply of loanable funds mean that the real interest rate does not change.

7. a. The equilibrium real interest rate is 3 percent and the equilibrium quantity of loanable funds is $1.0 trillion.

b. The increase in the budget deficit increases the demand for loanable funds. Figure 7.7 shows the effect of the increase in the budget deficit. The demand for loanable funds curve shifts rightward from DLF0 to DLF1. The new equi-librium real interest rate is 4 percent and the equilibrium quantity of loanable funds is $1.3 trillion. The government budget deficit in-creased by $0.4 trillion but the quantity of loan-able funds increased by less—only $0.3 trillion. The difference, $0.1 trillion, is investment that was crowded out by the rise in the real interest rate from 3 percent to 4 percent brought about by the government budget deficit.

8. a. Figure 7.8 shows the loanable funds market in

Katiana and adds the world real interest rate at 3 percent. At that real interest rate, the quantity of loanable funds demanded is $1.4 trillion and the quantity of loanable funds supplied is $1.0 trillion. There is a shortage of $0.4 trillion loan-able funds. Katiana borrows this difference from the rest of the world so the quantity of loanable funds in the nation is $1.4 trillion. Katiana is a net borrower.



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b. When the world real interest rate rises to 4 per-cent, the quantity of loanable funds demanded in Katiana falls to $1.3 trillion and the quantity of loanable funds supplied rises to $1.1 trillion. Katiana remains a net borrower, but the amount it borrows from the rest of the world decreases to $0.2 trillion.

9. If the government budget deficit increases, the de-mand for loanable funds increases. The supply does not change so quantity of funds the country bor-rows from the rest of the world increases. The in-crease in the government budget deficit increases the country’s net foreign borrowing.

You’re the Teacher

1. “No, you’re making a fundamental error. Once you get the point here, I bet the chapter will be a lot eas-ier! Anyway, the deal is that you’re confusing in-vestment and saving. ‘Investment’ means the purchase of new capital goods; that is, investment refers to buying the actual capital good. When you

think about your funds in a savings account, you’re thinking about ‘saving.’ And, yeah, I agree with you that if the real interest rate you get on your saving increases, you’ll save more. In fact, that’s exactly what our book says because saving is a major com-ponent of the supply of loanable funds! And we know that when the real interest rate rises, the sup-ply of loanable funds increases. But when you think about investment, you have to realize that the real interest rate is a cost of investment. It’s the same way with you and me: If the real interest rate goes up, I know that I am less likely to borrow to buy a car or anything else. Companies behave the same way: If the real interest rate goes up, companies will borrow less, cutting back on their investments. So, you can see that when the real interest rate rises, the quantity of investment demanded decreases. And because investment is a major component of the demand for loanable funds, you can now see why an increase in the real interest decreases the quantity of loanable funds demanded.”

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C h a p t e r Q u i z

11. A government budget deficit a. increases the supply of loanable funds. b. decreases the supply of loanable funds. c. increases the demand for loanable funds. d. decreases the demand for loanable funds.

12. An increase in expected future income shifts the a. demand for loanable funds curve rightward. b. demand for loanable funds curve leftward. c. supply of loanable funds curve rightward. d. supply of loanable funds curve leftward.

13. An increase in default risk ____ the real interest rate and ____ the quantity of loanable funds. a. raises; decreases b. raises; increases c. lowers; decreases d. lowers; increases

14. The supply of loanable funds curve has a negative slope. The demand for loanable funds curve has a positive slope. a. Both sentences are true. b. The first sentence is true and the second is false. c. The first sentence is false and the second is true. d. Both sentences are false.

15. National saving is equal to a. private saving plus government saving. b. investment minus private saving. c. investment plus government saving. d. net investment plus depreciation.

16. If firms become more optimistic about the future, then expected profit ____ and the demand for loan-able funds curve shifts ____. a. rises; rightward b. rises; leftward c. falls; rightward d. falls; leftward

17. The crowding out effect can occur when the a. country is an international borrower. b. supply of loanable funds increases. c. government budget deficit increases. d. demand for investment increases.

18. If the supply of loanable funds increases more than the demand for loanable funds, then the real interest rate ____ and the amount of loanable funds ____. a. rises; increases b. rises; decreases c. falls; increases d. falls; decreases

19. A financial institution ____ a borrower and ____ a lender. a. is not; is not b. is not; is c. is; is not d. is; is

10. If a nation’s exports exceed its imports, then net exports are ____ and the nation ____ the rest of the world. a. negative; lends to b. negative; borrows from c. positive; lends to d. positive; borrows from.

The answers for this Chapter Quiz are on page 253

Chapt er 7 FINANCE, SAVING, AND...

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