ECON1110_HW4_solutions

# ECON1110_HW4_solutions - Introductory Microeconomics ECON...

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Introductory Microeconomics – ECON 1110 Homework Assignment #4 Suggested Solution 1. Initially there are only private borrowers and lenders in the mortgage market. The price elasticity of demand for loans is 2. a. Draw the initial equilibrium interest rate and quantity of mortgages. The initial equilibrium price and quantity are ( r * , Q * ). b. If the Federal Reserve wanted to decrease the interest rate to 8%, how many loans would it have to supply? Draw the new supply curve and equilibrium. (Note: the Fed does not pass a law that makes the maximum interest rate 8%, it increases its own supply of loans in order to drive the interest rate down). If the Federal Reserve wanted to decrease the interest rate to 8%, it increases its own supply of loans in order to drive the interest rate down. The market supply curve will shift to the right. In the new equilibrium, D new =S New , as demonstrated in the following diagram. We know the price elasticity of demand for loans is 2. At the initial equilibrium, the interest rate r initial =10% and the total number of loans Q initiall = 1 million. Plugging these values into the formula for the price elasticity of demand for loans and solving for Q New , yields: ED=% Δ D/% Δ P=( Δ Q/ Δ P)*(P/Q) = ((Q New -Q Initial )/( P New -P Initial ))*( P Initial / Q Initial )= -2 Q New =1.4m. According to the new equilibrium, the Fed needs to supply 1.4 million. Note: This is a poorly posed question.. Given the information we have for the question, we only can get the total quantity demanded in the new equilibrium. While it is more interesting for us to get the additional number of loans the government needs to supply (eg. Q new -Q’), we don’t have more information for the elasticity of supply curve and it is not convenient to get the answer. r r* Q D Q* S

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2. Pawn shops often operate like small banks in that they make short term loans. Pawn shops demand collateral in the form of wedding rings, power tools, or anything else that can be readily resold. People leave the items with the pawn shops, accept cash, and then have a fixed amount of time to repay the loan with interest, and reclaim their collateral items. If the people fail to repay the loan by the appropriate time, they do no have to repay the loan, but they lose the collateral. Critics point out that the interest rates that Pawn Shops charge seem exorbitant, often exceeding 20% per month.
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