Economics Final Quiz

Economics Final Quiz - Savings and Capital Formation Things...

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Savings and Capital Formation Things to focus upon for the exam: Chapter # 9. 1. National saving provides the funds needed for investment. 2. Firms acquire new goods because such investment is profitable. 3. Firms’ willingness to acquire new factories and machines depends on the expected benefit of using them exceeding the expected cost of using them. 4. On the cost side, two important factors in the decision to invest are a. the price of capital goods and b. the real interest rate (the financing cost if the funds are borrowed; the lost interest if they are not) 5. On the benefit side, the key factor is the value of the marginal product of new capital, which should be calculated net of both operating and maintenance expenses and taxes paid on the revenue the capital generates. 1. Financial markets work to equalize the supply of saving (by households, firms, and the government) and demand for saving (by firms that want to purchase or construct new capital). 2. In the graph showing market the saving curve is upward-sloping because increases in the real interest rate stimulate saving. 3. The demand is shown as a downward-sloping curve because higher real interest rates increase the cost of borrowing and reduce firms’ willingness to invest. 4. In equilibrium, desired investment must equal desired national saving. 5. The real interest rate functions as a price, clearing the market for saving as prices do in other markets. 6. Changes in factors other than the real interest rate that affect the supply of or demand for saving will shift the curves, leading to a new equilibrium in the financial market. 7. Factors affecting supply and demand: a. The effects of new technology: new technology increases the marginal product of new capital, increasing the demand for saving and causing the real interest rate to rise. b. An increase in the government budget deficit results in a decrease in national saving, causing the saving curve to shift to the left and the real interest rate to rise. c. The tendency of government budget deficits to reduce investment spending is called crowding out.
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Answers to Problems 7a. Ellie and Vince’s ownership costs equal their general expenses (maintenance, taxes, and insurance) plus their mortgage interest costs. General expenses are 4% of $200,000 = $8,000 per year, and interest expenses are 6% of $200,000 = $12,000 per year, so the total ownership cost is $20,000 per year. This exceeds the cost of renting ($1500 per month for 12 months, or $18,000), so Ellie and Vince should rent rather than buy. b. If Ellie and Vince are willing to pay $2,000 per month, or $24,000 per year, to rent, then they are better off buying (the cost of buying is lower than the cost of renting an equivalent house). c. If the real interest rate is 4%, then interest costs are 4% of $200,000 = $8,000, and total ownership costs are $16,000, less than the $18,000 Ellie and Vince are willing to pay in part a.
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