Homework Answers

Chapter 26
Questions for Review: 3, 6
3. National saving is the amount of a nation's income that is not spent on
consumption or government purchases. Private saving is the amount of
income that households have left after paying their taxes and paying
for their consumption. Public saving is the amount of tax revenue that
the government has left after paying for its spending. The three
variables are related because national saving equals private saving
plus public saving.
6. A government budget deficit arises when the government spends more
than it receives in tax revenue. Because a government budget deficit
reduces national saving, it raises interest rates, reduces private
investment, and thus reduces economic growth.

Problems and Applications: 1, 5, 7, 8, 9

1. a. The bond of an eastern European government would pay a higher
interest rate than the bond of the U.S. government because there
would be a greater risk of default.
b. A bond that repays the principal in 2040 would pay a higher interest
rate than a bond that repays the principal in 2015 because it has a
longer term to maturity, so there is more risk to the principal.
c. A bond from a software company you run in your garage would pay
a higher interest rate than a bond from Coca-Cola because your
software company has more credit risk.
d. A bond issued by the federal government would pay a higher
interest rate than a bond issued by New York State because an
investor does not have to pay federal income tax on the bond from
New York State.
5. Private saving is equal to (Y C T) = 10,000 6,000 1,500 = 2,500.
Public saving is equal to (T G) = 1,500 1,700 = -200.
National saving is equal to (Y C G) = 10,000 6,000 1,700 =
2,300.
Investment is equal to saving = 2,300.
The equilibrium interest rate is found by setting investment equal to
2,300 and solving for r:

3,300 100r = 2,300.

100r = 1,000.
r = 10 percent.
7. a. Harry will have $1,000(1 + 0.05) = $1,050. Ron will have
$1,000(1 + 0.08) = $1,080. Hermione will have $1,000(1 +
0.20) = $1,200.
b. Each student would compare the expected rate of return on his
or her own project with the market rate of interest (r). If the
expected rate of return is greater than r, the student would

borrow. If the expected rate of return is less than r, the student

would lend.
c. If r = 7%, Harry would want to lend while Ron and Hermione
would want to borrow. The quantity of funds demanded would be
$2,000, while the quantity supplied would be $1,000.
If r = 10%, only Hermione would want to borrow. The quantity of
funds demanded would be $1,000, while the quantity supplied
would be $2,000.
d. The loanable funds market would be in equilibrium at an interest
rate of 8%. Harry would want to lend and Hermione would want
to borrow. Ron would use his own savings for his project, but
would want to neither borrow nor lend. Thus quantity demanded
= quantity supplied = $1,000.
e. Harry will have $1,000(1 + 0.08) = $1,080. Ron will have
$1,000(1 + 0.08) = $1,080. Hermione will have $2,000(1 +
0.20) $1,000(1 + 0.08) = $2,400 $1,080 = $2,320. Both
borrowers and lenders are better off. No one is worse off.

Figure 1
8. a. Figure 1 illustrates the effect of the $20 billion increase in
government borrowing. 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 $20
billion reduces the supply of loanable funds at each interest rate by
$20 billion, so the new supply curve, S2, is shown by a shift to the
left of S1 by exactly $20 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.
b. Because 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 total loanable funds (and thus both investment and
national saving) decline by less than $20 billion, while public saving

declines by $20 billion and private saving rises by less than $20
billion.
c. 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 2 shows.

Figure 2

Figure 3
d. 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 3 shows.
e. 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.
Thus, 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.
9. a. If new regulations increase the cost of investment, the demand
for loanable funds will decline as shown in Figure 4. This will
reduce the equilibrium interest rate along with the levels of
saving and investment. With a reduction in investment, the
economy will face a lower rate of economic growth in the long
run.

Figure 4
b. If the new regulations improve savers confidence in the
financial system, the supply of loanable funds will increase. The
impact can be seen in Figure 5. The interest rate will fall, but
saving and investment will rise. Greater investment will increase
the rate of economic growth in the long run.

Figure 5

Chapter 27
Problems and Applications: 2, 3, 5, 7, 10
2. a. The present value of $15 million to be received in four years at an
interest rate of 11% is $15 million/(1.11)4 = $9.88 million. Because
the present value of the payoff is less than the cost, the project
should not be undertaken.
The present value of $15 million to be received in four years at an
interest rate of 10% is $15 million/(1.10)4 = $10.25 million. Because
the present value of the payoff is greater than the cost, the project
should be undertaken.

The present value of $15 million to be received in four years at an

interest rate of 9% is $15 million/(1.09)4 = $10.63 million. Because
the present value of the payoff is greater than the cost, the project
should be undertaken.
The present value of $15 million to be received in four years at an
interest rate of 8% is $15 million/(1.08)4 = $11.03 million. Because
the present value of the payoff is greater than the cost, the project
should be undertaken.
b. The exact cutoff for the interest rate between profitability and
nonprofitability is the interest rate that will equate the present
value of receiving $15 million in four years with the current cost of
the project ($10 million):
$10 = 15/(1 + x)4
10(1 + x)4 = 15
(1 + x)4 = 1.5
1 + x = (1.5)0.25
1 + x = 1.1067
x = 0.1067
Therefore, an interest rate of 10.67% would be the cutoff between
profitability and nonprofitability.

3. a.
Bond A: $8,000/(1 + 0.035)20 = $8,000/1.9898 = $4,020.50
Bond B: $8,000/(1 + 0.035)40 = $8,000/3.9593 = $2,020.56
b.
Bond A: $8,000/(1 + 0.07)20 = $8,000/3.870 = $2,067.18
Bond B: $8,000/(1 + 0.07)40 = $8,000/14.974 = $539.26
Bond B has the larger percentage change in value.
c. The value of a bond falls when the interest rate increases, and
bonds with a longer time to maturity are more sensitive to changes
in the interest rate.
5. a. A sick person is more likely to apply for health insurance than a well
person is. This is adverse selection. Once a person has health
insurance, he may be less likely to take good care of himself. This is
moral hazard.
b. A risky driver is more likely than a safe driver to apply for car
insurance. This is adverse selection. Once a driver has insurance,
he may drive more recklessly. This is adverse selection.
7. Shareholders will likely demand a higher return due to the stocks firmspecific risk. Firm-specific risk is risk that affects only that particular
stock. All stocks in the economy are subject to market risk.
10. a. Yes, Jamal is risk averse. The marginal utility of an additional dollar
of wealth is diminishing. Figure 1 shows Jamals utility function.

Figure 1
b.

The expected value of option A = U(W = $4 million) = 2,000.

The expected value of option B = (0.6) U(W = $1 million) + 0.4
U(W = $9 million) = (0.6) 1,000 + (0.4) 3,000 = 600 + 1,200 =
1,800.
Jamal should choose option A.

Chapter 28
Questions for Review: 1, 2, 4
1. The BLS categorizes each adult (16 years of age and older) as either
employed, unemployed, or not in the labor force. The labor force
consists of the sum of the employed and the unemployed. The
unemployment rate is the percentage of the labor force that is
unemployed. The labor-force participation rate is the percentage of the
total adult population that is in the labor force.
2. Unemployment is typically short term. Most people who become
unemployed are able to find new jobs fairly quickly. But some
unemployment is attributable to the relatively few workers who are
jobless for long periods of time.
4. Minimum-wage laws are a better explanation for unemployment among
teenagers than among college graduates. Teenagers have fewer jobrelated skills than college graduates do, so their wages are low enough
to be affected by the minimum wage. College graduates' wages
generally exceed the minimum wage.

Problems and Applications: 1, 3, 4, 5, 6, 8

1. The labor force consists of the number of employed (139,445,000) plus
the number of unemployed (15,260,000), which equals 154,705,000.
To find the labor-force participation rate, we need to know the size of
the adult population. Adding the labor force (154,705,000) to the
number of people not in the labor force (82,614,000) gives the adult
population of 237,319,000. The labor-force participation rate is the
labor force (154,705,000) divided by the adult population
(237,319,000) times 100%, which equals 65.2%.

The unemployment rate is the number of unemployed (15,260,000)

divided by the labor force (154,705,000) times 100%, which equals
9.9%.
3. The fact that employment increased 6.8 million while unemployment
declined 1.1 million is consistent with growth in the labor force of 5.7
million workers. The labor force constantly increases as the population
grows and as labor-force participation increases, so the increase in the
number of people employed may always exceed the reduction in the
number unemployed.
4. a. If an auto company goes bankrupt and its workers immediate begin
looking for work, the unemployment rate will rise and the
employment-population ratio will fall.
b. If some of the unemployed auto workers give up looking for a job,
the unemployment rate will fall and the employment-population
ratio will remain the same.
c. If numerous students graduate from college and cannot find work,
the unemployment rate will rise and the employment-population
ratio will remain unchanged.
d. If numerous students graduate from college and immediately begin
new jobs, the unemployment rate will fall and the employmentpopulation ratio will rise.
e. If a stock market boom induces earlier retirement, the
unemployment rate will rise and the employment-population ratio
will fall.
f.

Advances in health care that prolong the life of retirees will not
affect the unemployment rate and will lower the employmentpopulation ratio.

5. a. A construction worker who is laid off because of bad weather is

likely to experience short-term unemployment, because the worker
will be back to work as soon as the weather clears up.
b. A manufacturing worker who loses her job at a plant in an isolated
area is likely to experience long-term unemployment, because there
are probably few other employment opportunities in the area. She
may need to move somewhere else to find a suitable job, which
means she will be out of work for some time.
c. A worker in the stagecoach industry who was laid off because of the
growth of railroads is likely to be unemployed for a long time. The
worker will have a lot of trouble finding another job because his
entire industry is shrinking. He will probably need to gain additional
training or skills to get a job in a different industry.
d. A short-order cook who loses his job when a new restaurant opens
is likely to find another job fairly quickly, perhaps even at the new
restaurant, and thus will probably have only a short spell of
unemployment.
e. An expert welder with little education who loses her job when the
company installs automatic welding machinery is likely to be
without a job for a long time, because she lacks the technological

skills to keep up with the latest equipment. To remain in the welding

industry, she may need to go back to school and learn the newest
techniques.

Figure 2
6. Figure 2 shows a diagram of the labor market with a binding minimum
wage. At the initial minimum wage (m1), the quantity of labor supplied
L1S is greater than the quantity of labor demanded L1D, and
unemployment is equal to L1S L1D. An increase in the minimum wage
to m2 leads to an increase in the quantity of labor supplied to L2S and a
decrease in the quantity of labor demanded to L2D. As a result,
unemployment increases as the minimum wage rises.
8. a. Wages between the two industries would be equal. If not, new
workers would choose the industry with the higher wage, pushing
the wage in that industry down.
b. If the country begins importing autos, the demand for domestic
auto workers will fall. If the country begins to export aircraft, there
would be an increase in the demand for workers in the aircraft
industry.
c. In the short run, wages in the auto industry will fall, while wages in
the aircraft industry will rise. Over time, new workers will move into
the aircraft industry bringing its wage down until wages are equal
across the two industries.
d. If the wage does not adjust to its equilibrium level, there would be a
shortage of workers in the aircraft industry and a surplus of labor
(unemployment) in the auto industry.