Chapter 10 .

Investment, Saving, and the Real Interest Rate

171

Investment,
Saving,
and the
Real
ANSWERS TO CHECKPOINTS
Interest

10
Chapter

CHECKPOINT 10.1 Physical Capital and Financial Capital

1.

Annie runs a fitness center. On December 31, 2007, she bought an existing
business with exercise equipment and a building worth $300,000. During
2008, business was poor, so she sold some of her equipment for $100,000.
What was Annies gross investment, depreciation, and net investment
during 2008? What was the value of Annies capital at the end of 2008?
Annies gross investment during 2008 was $100,000 because she sold
some of her capital. Annies depreciation during 2008 was 0. Annies net
investment during 2008 was $100,000, which equals gross investment
($100,000) minus depreciation ($0). Annes capital equals her capital at
the beginning of 2008, $300,000, plus her net investment in 2008,
$100,000, so her capital at the end of 2008 was $200,000.

2.

Karrie is a golf pro, and after she paid taxes, her income from golf and
from stocks and bonds was $1,500,000 in 2008. At the beginning of 2008,
she owned $900,000 worth of stocks and bonds. At the end of 2008,
Karries stocks and bonds were worth $1,900,000. How much did Karrie
save during 2008 and how much did she spend on consumption goods
and services?
Karries wealth increased by $1,000,000 in 2008. So her saving in 2008 was
$1,000,000. (This point assumes no capital gains or losses on her stocks
and bonds.) Her income after taxes was $1,500,000. Her consumption
equals her income minus her saving, which is $1,500,000 $1,000,000 =
$500,000.

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Part 3 . THE REAL ECONOMY

CHECKPOINT 10.2 The Market for Loanable Funds

In 2008, the Lee family had a disposable income of $80,000, wealth of
$140,000, and an expected future income of $80,000 a year. At a real interest
rate of 4 percent a year, the Lee family saves $15,000 a year; at a real interest
rate of 6 percent a year, they save $20,000 a year; and at a real interest rate of 8
percent, they save $25,000 a year. Use this information to answer Exercises 1
and 2.
1. Draw a graph of the Lee familys supply of loanable funds curve.
The graph illustrating the Lee familys supply
of loanable funds curve is in Figure 10.1.
2.

In 2009, suppose that the stock market crashes

and the Lee familys wealth decreases by 50
percent. Explain how this decrease in wealth
influences the Lee familys supply of loanable
funds curve.
If the stock market crashes so that the Lee
familys wealth decreases, then the Lee family
will increase its saving. As a result, the Lee
familys supply of loanable funds increases
and its supply of loanable funds curve shifts
rightward.

3.

Draw graphs that illustrate the effect of an

increase in the demand for loanable funds and
an even larger increase in the supply of
loanable funds on the real interest rate and the equilibrium quantity of
loanable funds.
The increase in the demand for loanable funds
raises the real interest rate and increases the
equilibrium quantity of loanable funds. The
increase in the supply of loanable funds lowers
the real interest rate and increases the
equilibrium quantity of loanable funds. If the
change in the supply of loanable funds exceeds
the change in the demand for loanable funds,
the real interest rate falls. Both changes
increase the equilibrium quantity of loanable
funds, so the equilibrium quantity of loanable
funds increases.
Figure 10.2 illustrates this situation. The
increase in the demand for loanable funds

Chapter 10 . Investment, Saving, and the Real Interest Rate

173
shifts the demand for loanable funds curve rightward from DLF0 to DLF1.
The increase in the supply of loanable funds shifts the supply of loanable
funds curve rightward from SLF0 to SLF1. As Figure 10.2 shows, the real
interest rate falls, from 6 percent a year to 5 percent a year. The
equilibrium quantity of loanable funds increases, from $11 trillion to $13
trillion.

CHECKPOINT 10.3 Government in Loanable Funds Market

Real
Loanable
Loanable
In the loanable funds market set out in the
interest
funds
funds
table, the demand for loanable funds
rate
demanded
supplied
increases by $1 trillion at each real interest
(percent
(trillions of 2000 dollars
rate and the private supply of loanable
per year)
per year)
funds increases by $2 trillion at each
4
8.5
5.5
interest rate.
5
8.0
6.0
6
7.5
6.5
1. If the government budget is balanced,
7
7.0
7.0
what are the real interest rate, the
8
6.5
7.5
quantity of loanable funds, investment,
9
6.0
8.0
and private saving? Is there any
10
5.5
8.5
crowding out in this situation?
The real interest rate is 6 percent, and the quantity of loanable funds,
private saving, and investment are all $8.5 trillion. There is no crowding
out.

2.

If the government budget deficit is $1 trillion, what are the real interest
rate, the quantity of loanable funds, investment, and private saving? Is
there any crowding out in this situation?
The equilibrium real interest rate becomes 7 percent. The equilibrium
quantity of loanable funds is $8.0 trillion, the equilibrium quantity of
investment is $8.0 trillion, and the equilibrium quantity of private saving
is $9.0 trillion. There is crowding out of $500 billion of investment.

3.

If governments want to stimulate the quantity of investment and increase

it to $9 trillion, what must they do?
Assuming no Ricardo-Barro effect, the government needs to have a budget
surplus of $1 trillion. In this case, the new equilibrium is at a real interest
rate of 5 percent, the quantity of investment is $9 trillion, and the quantity
of private saving is $8 trillion.

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Part 3 . THE REAL ECONOMY

ANSWERS TO CHAPTER CHECKPOINT

Problems
1.

On January 1, 2006, Terrys Towing Service owned 4 tow trucks valued at

$300,000. During 2006, Terrys bought 2 new trucks for a total of $180,000.
At the end of 2006, the market value of all the firms trucks was $400,000.
What was Terrys gross investment, depreciation, and net investment?
His gross investment was $180,000. His depreciation was $80,000. His net
investment, which is equal to gross investment minus depreciation, was
$100,000.

The Bureau of Economic Analysis reported that the U.S. capital stock was
$23.0 trillion at the end of 1999, $23.8 trillion at the end of 2000, and $24.4
trillion at the end of 2001. Depreciation in 2000 was $1.0 trillion, and gross
investment during 2001 was $1.6 trillion (all in 1996 dollars). Use this
information to answer Problems 2 and 3.
2. Calculate U.S. net investment and gross investment during 2000.
Net investment equals the change in the capital stock. So in 2000, U.S. net
investment was $23.8 trillion $23.0 trillion, which is $0.8 trillion. Gross
investment equals net investment plus depreciation. So in 2000, U.S. gross
investment was $0.8 trillion + $1.0 trillion, which is $1.8 trillion.
3.

Calculate U.S. net investment and depreciation during 2001.

Net investment equals the change in the capital stock. So in 2001, U.S. net
investment was $24.4 trillion $23.8 trillion, which is $0.6 trillion.
Depreciation equals gross investment minus net investment. So in 2001,
U.S. depreciation was $1.6 trillion $0.6 trillion, which is $1.0 trillion.

4.

Mike takes a summer job washing cars. During the summer, he earns an
after-tax income of $3,000 and he spends $1,000 on goods and services.
What was Mikes saving during the summer and the change, if any, in his
wealth?
Mikes saving is equal to his after-tax income minus his consumption
expenditure, which is $3,000 $1,000 =$2,000. Mikes wealth increased by
the amount of his saving, $2,000.

5.

What is the market for financial capital? What is financial capital? Is the
market for financial capital a national market or a global market?
Financial markets are the collection of households, firms, governments,
banks, and other financial institutions that lend and borrow. Financial
markets include the stock market, the bond market, the short-term
securities market, and the market for loans. Financial assets, such as
stocks, bonds, and short-term securities are traded in financial markets.
The global financial market determines the real interest rate.

Chapter 10 . Investment, Saving, and the Real Interest Rate

175
6.

Explain why when the real interest rate rises, the demand for loanable
funds does not change but the quantity of funds demanded decreases.
An increase in the real interest rate leads to a movement upward along the
demand for loanable funds curve The demand for loanable funds curve
does not shift. The quantity of loanable funds demanded decreases. The
factor that changes the demand for loanable funds, that is, changes the
entire relationship between the real interest rate and the quantity of
loanable funds demanded is the expected rate of profit. When the
expected rate of profit changes, the demand for loanable funds changes
and the loanable funds demand curve shifts.

7.

A new technology is developed that increases firms expected profit.

Draw a graph to show the effect of this development on the market for
loanable funds. What are the effects of this development on the
equilibrium real interest rate and investment?
New technology that increases the expected
rate of profit increases investment demand.
The increase in the demand for investment
increases the demand for loanable funds. As a
result, the demand for loanable funds curve
shifts rightward. Figure 10.3 shows this
change as the shift in the demand for loanable
funds curve from DLF0 to DLF1. The increase
in the demand of loanable funds raises the
real interest rate, in Figure 10.3 from 5 percent
to 6 percent. Figure 10.3 also shows that the
increase in the demand for loanable funds
increases the equilibrium amount of loanable
funds, in the figure from $10 trillion to $12
trillion. Equivalently, the equilibrium quantity
of saving and investment increase from $10
trillion to $12 trillion.

8.

During the 1990s, the invention and use of fiber-optic technologies

required billions of dollars to be spent laying new cables under the
oceans and launching communications satellites. Explain, using a graph,
the effect of this event on the market for loanable funds.
The invention and use of fiber optics in the 1990s decade lead to an
increase in investment demand. The increase in investment demand
increases the demand for loanable funds so that the demand curve for
loanable funds shifts rightward. Figure 10.4 (on the next page) shows this
change as the shift in the demand for loanable funds curve from DLF0 to

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Part 3 . THE REAL ECONOMY

DLF1. The increase in the demand for

loanable funds raises the equilibrium real
interest rate and increases the equilibrium
quantity of loanable funds. In Figure 10.4, the
equilibrium real interest rate rises from 5
percent to 6 percent and the equilibrium
quantity of loanable funds increases from $10
trillion to $12 trillion. The increase in the
equilibrium quantity of loanable funds means
that the equilibrium quantity of saving and
investment also increase, in Figure 10.4 from
$10 trillion to $12 trillion.
9.

With an increase in global tension during

2005 and 2006, many governments increased
defense
spending,
which
decreased
government budget surpluses. Show, on a
graph, the effects of a decrease in government
budget surpluses if there is no Ricardo-Barro effect. Explain how the
effects differ if there is a partial Ricardo-Barro effect.
Figure 10.5 shows the initial private supply of
loanable funds curve, PSLF0 and the initial
total supply of loanable funds curve, SLF0.
The horizontal difference between the two
curves, indicated by the arrow, is the amount
of the initial government budget surpluses.
If the governments begin to run smaller
budget surpluses and there is no RicardoBarro effect, the private supply of loanable
funds curve remains the same, PSLF0. The
total supply of loanable funds curve shifts
leftward, in the figure to SLF1. If the demand
for loanable funds does not change, in
equilibrium the real interest rate will rise and
the quantity of investment will decrease.
If the governments begin to run smaller
budget surpluses and there is a full Ricardo-Barro effect, the total supply
of loanable funds curve remains the same, SLF0. The private supply of
loanable funds curve shifts rightward to PSLF1 because households
increase their saving to offset the lessened government saving. If the

Chapter 10 . Investment, Saving, and the Real Interest Rate

177
demand for loanable funds does not change, in equilibrium the real
interest rate will not change and the quantity of investment will not
change.
If there is a partial Ricardo-Barro effect, the effects are partway between
those with no Ricardo-Barro effect and a full Ricardo-Barro effect. The
private supply of loanable funds curve shifts rightward but not all the
way to PSLF1 and the total supply of loanable funds curve shifts leftward
but not all the way SLF1.
IMF Warning Over Slowing Growth
The global economy may face a marked slowdown next year as a result of the
turmoil in financial markets, the International Monetary Fund has warned.
The IMF said the global credit squeeze would test the ability of the economy
to continue expanding at recent rates. While future economic stability could
not be taken for granted, there was plenty of evidence that the global
economy remained durable, it added.
BBC News, October 10, 2007
Use this information to answer Problems 10 and 11.
10. Explain how turmoil in global financial markets might effect the demand
for loanable funds, investment, and global economic growth in the
future.
The turmoil in financial markets might lead some people to decrease their
saving because of fear that they might lose these funds due to the turmoil.
As a result, the supply of loanable funds might decrease, which would
push up the real interest rate. The primary source demanding loanable
funds is business firms who demand these funds to make investment. If
the real interest rate rises, the quantity of loanable funds demanded will
decrease as businesses cancel no-longer profitable investments. With less
investment there will be less capital and so the growth in potential GDP
will slow.
11. What might be the evidence that the global economy will continue to
grow?
Growth will remain if investment continues to be robust. Investment
depends on the real interest rate and the expected profit rate. At the time
of the report, there seemed to be little sign that the global credit
squeeze was resulting in a sharply higher real interest rate, which could
serve to decrease investment. The historical evidence is that the demand
for and supply of loanable funds increase at about the same rate, so there
is no trend in the real interest rate and the IMFs report does not explicitly
mention a higher real interest. It also is likely that profit expectations have
not plummeted. Survey data could be used to try to get a read on profit

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Part 3 . THE REAL ECONOMY

expectations. But perhaps more objectively, GDP continued to expand at a

reasonably fast clip in many countries and this relatively rapid expansion
likely increased future profit opportunities.

Exercises
1.

On January 1, 2007, Sophies Sunlounge owned 4 tanning beds valued at

$20,000. During 2007, Sophies bought 3 new beds at a total cost of
$12,000, and at the end of the year, the market value of all of Sophies
beds was $26,000. What was Sophies gross investment, depreciation, and
net investment?
Her gross investment was $12,000 for the new beds. Her net investment is
the difference in the value of the capital over the year and is $6,000.
Depreciation equals gross investment minus net investment, so her
depreciation was $6,000.

2.

The numbers in the second

Wealth
Saving
column of the table are the
(billions of
(billions of
Federal Reserves estimates of
Year
1996 dollars) 1996 dollars)
1998
35,681
292
the personal wealth at the end
1999
39,810
154
of each year. The numbers in
2000
38,353
63
the third column are the
2001
36,450
108
Bureau of Economic Analysiss
estimates of personal saving each year. In which years did the change in
wealth exceed saving? In which years did saving exceed the change in
wealth? Given the definitions of saving and wealth, how can the change
in wealth differ from saving?
The change in wealth exceeded the change in saving in 1998 and 1999.
Saving exceeded the change in wealth in 2000 and 2001. The change in
wealth can exceed saving if the prices of the assets included in wealth
increase during the year. In other words, the change in wealth can exceed
the change in saving if there are capital gains.

3.

Cindy takes a summer job painting houses. During the summer, she
earns an after-tax income of $5,000 and she spends $2,000 on living
expenses. What was Cindys saving during the summer and the change, if
any, in her wealth?
Cindys saving is equal to her after-tax income minus her consumption
expenditure, which is $5,000 $2,000 =$3,000. Cindys wealth increased
by the amount of her saving, $3,000.

Chapter 10 . Investment, Saving, and the Real Interest Rate

179
4.

Explain the effect on the supply of loanable funds of an increase in

wealth, an increase in future income, and a cut in current income taxes.
The greater the wealth a household has accumulated, other things
remaining the same, the less it will save. The reason is that the household
already has assets to draw upon to consume. Private saving supply
decreases so the supply of loanable funds decreases.
The higher a households expected future income, other things remaining
the same, the smaller is its saving. The reason is that the household will
prefer to consume more now knowing it can save more later when its
disposable income is expected to rise. Private saving supply decreases so
the supply of loanable funds decreases.
A cut in current income taxes increases disposable income in the present.
This change increases private saving supply and so increases the supply
of loanable funds.

5.

During the 1990s, a stock market boom increased wealth by trillions of

dollars. Explain the effect of this boom on the equilibrium real interest
rate in the global financial market and on global investment and global
saving.
The increase in wealth decreased peoples saving and thereby decreased
the supply of loanable funds. The decrease in the supply of loanable
funds raised the equilibrium real interest and decreased the equilibrium
quantity of loanable funds. The equilibrium quantity of investment and
saving also decreased.

During the late 1990s, governments around the world had large budget
deficits. In the early 2000s, government budget deficits began to turn into
surpluses. Use this information to answer Exercises 6 and 7.
6. Show, on your graph, the effects of a switch from a government budget
deficit to a government budget surplus if there is no Ricardo-Barro effect.
Figure 10.6 shows the initial private saving
supply curve as PSLF0 and the initial total
saving supply curve as SLF0. The horizontal
difference between the two curves, indicated
by the arrow, is the amount of the initial
government
budget
deficits.
If
the
governments begin to run budget surpluses
and there is no Ricardo-Barro effect, the
private saving curve remains the same, PSLF0.
The total saving supply curve shifts rightward
to SLF1.

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7.

Part 3 . THE REAL ECONOMY

What are the effects of a switch from a government budget deficit to a

government budget surplus if there is a partial Ricardo-Barro effect.
If the governments begin to run budget surpluses and there is no RicardoBarro effect, the total supply of loanable funds increases. In Figure 10.6,
the total supply of loanable funds curve shifts rightward from to SLF0 to
SLF1 so that in equilibrium the real interest rate falls and investment
increases. If the governments begin to run budget surpluses and there is a
total Ricardo-Barro effect, the total supply of loanable funds does not
change so that the supply of loanable funds curve remains SLF0. (The
private supply of loanable funds, saving, decreases one-to-one with the
increase in government saving so the private supply of loanable funds
curve shifts leftward to PSLF1.) In equilibrium, the real interest rate does
not change and investment does not change. If the governments begin to
run budget surpluses and there is a partial Ricardo-Barro effect, the effects
will be between the two extreme cases discussed above: the total supply of
loanable funds curve shifts rightward (but not all the way to SLF1) and the
private supply of loanable funds curve shifts leftward (but not all the way
to PSLF1.) In the equilibrium, the real interest falls, but not by as much as
in the case with no Ricardo-Barro effect and investment increases, but not
by as much as in the case with no Ricardo-Barro effect.

Greenspans Conundrum Spells Confusion for Us All

At the beginning of the year, the consensus was that bond yields would
rise ... Gradually, over February, the consensus has started to reassert itself.
Ten-year Treasury bond yields were hovering below 4 percent in the
early part of the month but now they are around 4.3 percent.
Because the consensus was that bond yields should be 5 percent by the
end of the year, most commentators have focused, not on why bond yields
have suddenly risen, but on why they were so low before.
A number of explanations for this conundrum have been advanced.
First, bond yields are being held artificially low by unusual buying.
Another [is that] ... bond yields reflect investors expectations for an economic
slowdown in 2005.
Philip Coggan, Financial Times, February 26,
2005
Use this information and the loanable funds market to answer Exercises 8
and 9.
8. Explain how unusual buying might lead to a low real interest rate.
Unusual buying means that the demand in the financial market for
bonds is unusually large. In this case, the unusually large demand will

Chapter 10 . Investment, Saving, and the Real Interest Rate

181
lead to bond prices being unusually high. Higher bond prices mean a
lower interest rate on the asset. So unusually high bond prices will create
unusually low interest rates on bonds.
9.

Explain how investors expectations for an economic slowdown might

lead to a low real interest rate.
Investors expectations of an economic slowdown mean that the expected
profit from investing in capital falls. The lower expected profit rate
decreases the demand for investment, which decreases the demand for
loanable funds. The fall in the demand for loanable funds then lowers the
equilibrium real interest rate.

Critical Thinking and Web Activities

1.

Look at the data provided in Eye on the U.S. Economy on page 243.
a. What fluctuates most and why: net investment, gross investment,
depreciation, or capital?
Net investment fluctuates the most because it increases during
expansions and decreases during recessions.
b. Why do you think net investment surged upward so strongly during
the 1990s?
Net investment surged upward because of major investments made in
the Internet and telecommunications sectors of the economy. In
addition, Y2K fears lead many firms to invest in new computer
equipment in the late 1990s.
c. How might you set about determining whether the swings in net
investment were changes in investment demand or changes in the
quantity of investment?
One way to determine if the swings in net investment are due to
changes in investment demand or changes in the quantity of
investment would be to look at the real interest rate. An increase in
investment demand leads to a higher real interest while an increase in
the quantity of investment is the result of a lower real interest rate.
d. Can you think of ways in which the fluctuations in investment might
be smoothed?
Investment can be smoothed by smoothing the real interest rate. It can
also be smoothed by government policy that taxes investment if it
surges upward and subsidizes investment if it plummets.
e. Do you think it would it be a good idea or a bad idea to smooth the
fluctuations? Why?
There seems no particularly good reason to believe that smoothing
investment is a good idea. Each individual firm has the most accurate

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2.

Part 3 . THE REAL ECONOMY

assessment of how much investment it needs to undertake, so

investment probably ought to be left alone.
China, India, and Indonesia account for about half the worlds
population and are expanding at a rapid rate. Do these countries lend to
or borrow from the United States? As these countries become wealthier
and more similar to the United States, how do you think they will affect
the global market for financial capital? Would you expect the real interest
rate to rise, fall, or remain close to its current level? Why?
Currently these nations lend to the United States. As these economies
become wealthier, world demand for loanable funds (for investment) and
world supply of loanable funds (from saving) increase. Probably the two
effects are of similar magnitude, so the real interest will remain close to its
current level. If, however, investment opportunities increase in these
countries or if their people begin to emulate U.S. residents by saving less,
then the real interest rate will rise.

3.

During 2001, the Commerce Department reported that the U.S. saving
rate was negative. How can the saving rate be negative? Why might a
negative saving rate be something to worry about? How do you think
saving in the United States could be stimulated?
Saving can be negative if people, on net, are borrowing, in this case from
foreigners. A negative saving rate can be worrisome because at some point
the borrowing must be repaid. If the borrowing is used to finance
consumption expenditure, it will be more difficult to repay the loans.
Saving can be stimulated using government policies. For instance, the
government could decrease or eliminate taxes on interest income or gains
in the stock market.

4.

Visit the Web sites of the New York Stock Exchange, the London Stock
Exchange, and PACIFIC.
a. Find a stock that trades on both exchanges and obtain its current price
in New York and London.
Your students answers will vary and depend on the stock they select.
b. Find todays exchange rate between the U.S. dollar and the U.K.
pound.
Your students answers will vary and depend on the stock they select.
c. Use todays exchange rate to convert the London price to U.S. dollars.
Your students answers will vary and depend on the stock they select.
d. What is the difference in the two prices? Could you earn a profit by
buying in one market and selling in the other?
The one common feature among your students answers is that it
should not be possible to earn a profit. Any profit that they might

Chapter 10 . Investment, Saving, and the Real Interest Rate

183
think is present is almost surely the result of prices and/or the
exchange rate being for different times.
e. Why do you think the prices are so similar in the two stock markets?
The fact that no profit can be earned because the prices are so similar
reflects the point that the financial markets are a global market.
5. Open the file that provides data on saving rates in the United States and
the new industrial economies of East Asia.
a. Which of the countries has the highest saving rate and which has the
lowest?
The saving rate in East Asia averages near 30 percent. The saving rate
in the United States averages near 20 percent. The saving rate is much
higher in the Asian economies.
b. Of the factors that influence saving, do you think the differences
across these economies represent differences in the supply of saving
or differences in the quantity of saving supplied? Explain your
answer.
The difference is most likely a difference in the supply of saving. The
differences in the saving rates would be a difference in the quantity of
saving supplied only if the real interest rate was different in East Asia
than in the United States. The real interest rates in these countries are
probably similar because of the global financial market so the
difference is due to a difference in the supply of saving.
c. Of the influences on the supply of saving, which do you think might
account for the differences in saving rates that youve found?
Government saving in the Asian nations is always higher than that in
the United States, which accounts for part of the difference between
the saving rates. However, it is not all the difference because private
saving in the Asian nations is also larger. Of the three factors that
affect saving discussed in the text, the most likely variable that leads
Asian saving to be larger than U.S. saving is wealth, which will be less
in the Asian nations. Alternatively, there might be cultural differences
that favor more saving in Asian nations as well as more government
programs designed to increase saving in the Asian nations.

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Part 3 . THE REAL ECONOMY

ADDITIONAL EXERCISES FOR ASSIGNMENT

Questions
CHECKPOINT 10.1 Physical Capital and Financial Capital
1. Comment on the following statement: A person can only increase his or
her wealth by acquiring more goods and services.
2.

2a.
2b.
2c.
2d.
3.

Annie runs a fitness center. On December 31, 2007, she bought an existing
business with exercise equipment and a building worth $600,000. During
her first year of operation, business was poor. She sold some of her
equipment to a competitor for $200,000.
What was Annies gross investment during 2008?
What was Annies depreciation during 2008?
What was Annies net investment during 2008?
What was the value of Annies capital at the end of 2008?
Karrie is a golf pro, and after she paid taxes, her total income from golf and
from the stocks and bonds that she owns was $1,000,000 in 2008. At the
beginning of 2008, she owned $600,000 worth of stocks and bonds. At the
end of 2008, Karrie's stocks and bonds were worth $1,400,000. How much
did Karrie save during 2008 and how much did she spend on consumption
goods and services?

CHECKPOINT 10.2 The Market for Loanable Funds

4. Determine whether the following changes in the demand for loanable funds
and the supply of loanable funds will raise the real interest rate, lower the
real interest rate, leave the real interest rate unchanged, or have an
ambiguous effect on the real interest rate:
4a. Increase in the supply and an increase in the demand.
4b. Increase in the supply and a decrease in the demand.
4c. Decrease in the supply and a decrease in the demand.
CHECKPOINT 10.3 Government in Loanable Funds Market
Real interest Investment Private saving
5. Starting from the situation in
rate
the table, investment demand
(trillions of 2000 dollars per
(percent per
increases by $2 trillion at each
year)
year)
level of the real interest rate and
4
8.5
5.5
the supply of private saving
increases by $1 trillion at each
5
8.0
6.0
interest rate.
6
7.5
6.5
5a. If the government budget has
7
7.0
7.0
neither a surplus nor a deficit,
what are the real interest rate,
8
6.5
7.5
the quantity of investment, and
9
6.0
8.0
10

5.5

8.5

Chapter 10 . Investment, Saving, and the Real Interest Rate

185
the quantity of private saving? Is there any crowding out in this situation?
5b. 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 in this situation?
5c. If governments want to stimulate the quantity of investment and increase it
to $10 trillion, what must they do?
6.

Assume the government initially has a balanced budget. Next year the
government runs a $50 billion deficit. If the quantity of investment remains
the same, what other change must have occurred in this economy? (Hint:
Use the identity in Checkpoint 10.3 to answer this question.) What effect
was discussed in the chapter that sounds remarkably similar to the answer
that you provided?

Answers
CHECKPOINT 10.1 Physical Capital and Financial Capital
1. The statement is false. A persons wealth is the value of all the things that
the person owns. Saving, which is the amount of income that is not paid in
taxes or spent on consumption goods and services adds to wealth. But
wealth also increases when the value of assets risescalled capital gains.
2a. Annies gross investment during 2008 was $200,000 because she sold some
of her capital.
2b. Annies depreciation during 2008 was $0.
2c. Annies net investment during 2008 was $200,000, which equals gross
investment ($200,000) minus depreciation ($0).
2d. Annes capital at the end of 2008 equals her capital at the beginning of 2007,
$600,000, plus her net investment in 2008, $200,000, so her capital at the
end of 2008 was $400,000.
3.

Karries wealth increased by $400,000 in 2008. So her saving in 2008 was

$400,000. (This point assumes no capital gains or losses on her stocks and
bonds.) Her income after taxes was $1,000,000. Her consumption
expenditure equals her income minus her saving, which is $1,000,000
$400,000, $600,000.

CHECKPOINT 10.2 The Market for Loanable Funds

4a. The effect on the real interest rate is ambiguous because we do not know the
relative magnitudes of the changes. An increase in the supply of loanable
funds, other things being equal, lowers the real interest rate. However, other
things being equal, an increase in the demand for loanable funds raises the
real interest rate. The net effect is ambiguous.

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Part 3 . THE REAL ECONOMY

4b. The real interest rate will fall. The result is clear because both changes lower
the real interest rate.
4c. The effect on the real interest rate is ambiguous because we do not know the
relative magnitudes of the changes. A decrease in the supply of loanable
funds, other things being equal, raises the real interest rate. However, other
things being equal, a decrease in the demand for loanable funds lowers the
real interest rate. The net effect is ambiguous.
CHECKPOINT 10.3 Government in Loanable Funds Market
5a. The real interest rate is 8 percent a year, and the quantity of private saving
and investment are both $8.5 trillion. There is no crowding out.
5b. The real interest rate is now 9 percent a year, the quantity of investment is
$8.0 trillion and the quantity of private saving is $9.0 trillion. There is
crowding out of $500 billion of investment.
5c. Assuming no Ricardo-Barro effect, the government would need to have a
budget surplus of $3 trillion. In this case, the new equilibrium would be at a
real interest rate of 5 percent a year, the quantity of investment would be
$10 trillion, and the quantity of private saving would be $7 trillion.
6.

The following identity can help us answer this question: I = S + (NT G). If
initially there is a balanced budget, then NT and G are equal. That means
that initially I = S. Now, if the government runs a budget deficit of $50
billion, then NT G is negative (and equal to negative $50 billion). If
investment remains unchanged, then the formula shows that the only
adjustment that could be made is if somehow private saving increased by
$50 billion. The increase in the government budget deficit leading to a
similar sized increase in private saving is the Ricardo-Barro effect discussed
in the chapter.