11.1 financial markets
Review Activities
The original version of this chapter contained H5P content. You may want to remove or replace this element.
Practice Problems
No practice problems for this section.
External Resources
Khan Academy: Stocks versus Bonds (this goes into more detail than you need)
11.2 Financial markets, supply and demand, and interest
Review Activities
The original version of this chapter contained H5P content. You may want to remove or replace this element.
Practice Problems
Problem 11.2.1: Suppose that the current inflation rate is 4%. Tom wants to get a loan to buy a car. The bank decides that based on Tom’s risk, they want to earn a real return of 5%. What nominal interest rate should they charge him? Suppose that over the course of the loan the inflation rate actually turns out to be 6%. What was their real rate of return on the loan?
Answers: 9%; 3%
https://youtu.be/0JmRVXawnpQ
Problem 11.2.2: Draw the market for loanable funds in a state of equilibrium. Be sure to label all components.
Answer: See video for graph.
https://youtu.be/H6UUoU5zbW8
External Resources
Khan Academy: Introduction to Interest (Ignore compound interest.)
Khan Academy: Real and Nominal Return
Khan Academy: Nominal Interest, Real Interest, and Inflation Calculations
11.3 shifts in demand and supply in financial markets
Review Activities
The original version of this chapter contained H5P content. You may want to remove or replace this element.
Practice Problems
Problem 11.3.1: A new government program allows people to save money tax-free. Graphically show the impact of this new policy on the market for loanable funds. Be sure your graph is fully labeled. Also, provide a brief explanation for each step. What happens to the real interest rate and quantity of loanable funds?
Answer: This causes an increase in the supply of loanable funds (outward shift of supply). This causes a surplus of loanable funds. Therefore, the real interest rate falls. This results in a decrease in the quantity supplied of loanable funds and an increase in the quantity demanded for loanable funds. The new equilibrium interest rate is lower than the original equilibrium real interest rate. The new equilibrium quantity of loanable funds is greater than the original equilibrium quantity of loanable funds.
https://youtu.be/F322n1Gpp2c
Problem 11.3.2: Businesses find that investment projects are more profitable and therefore increase the number of projects conducted. Many of these projects require loans to complete. Graphically show the impact of this new business strategy on the market for loanable funds. Be sure your graph is fully labeled. Also, provide a brief explanation for each step. What happens to the real interest rate and quantity of loanable funds?
Answer: This causes an increase in the demand for loanable funds (outward shift of demand). This causes a shortage of loanable funds. Therefore, the real interest rate rises. This results in a decrease in the quantity demanded of loanable funds and an increase in the quantity supplied for loanable funds. The new equilibrium interest rate is greater than the original equilibrium real interest rate. The new equilibrium quantity of loanable funds is greater than the original equilibrium quantity of loanable funds.
https://youtu.be/OACD0LsBYqU
Problem 11.3.3: Consumers become pessimistic about the future of the economy and choose to make less large purchases. This means that people are buying less things that require loans. Graphically show the impact of this new consumption pattern on the market for loanable funds. Be sure your graph is fully labeled. Also, provide a brief explanation for each step. What happens to the real interest rate and quantity of loanable funds?
Answer: This causes a decrease in the demand for loanable funds (inward shift of demand). This causes a surplus of loanable funds. Therefore, the real interest rate decreases. This results in a decrease in the quantity supplied of loanable funds and an increase in the quantity demanded for loanable funds. The new equilibrium interest rate is less than the original equilibrium real interest rate. The new equilibrium quantity of loanable funds is less than the original equilibrium quantity of loanable funds.
https://youtu.be/72OzwbX2YIo
Problem 11.3.4: The stock market is doing very well which means that people are choosing to put more of their money in the stock market and less into banks. Graphically show the impact of this new consumption pattern on the market for loanable funds. Be sure your graph is fully labeled. Also, provide a brief explanation for each step. What happens to the real interest rate and quantity of loanable funds?
Answer: This causes a decrease in the supply of loanable funds (inward shift of supply). This causes a shortage of loanable funds. Therefore, the real interest rate increases. This results in a decrease in the quantity demanded of loanable funds and an increase in the quantity supplied for loanable funds. The new equilibrium interest rate is greater than the original equilibrium real interest rate. The new equilibrium quantity of loanable funds is less than the original equilibrium quantity of loanable funds.
https://youtu.be/bgDSvnP42-g
Problem 11.3.5: The government engages in expansionary fiscal policy by increasing government spending and cutting taxes. This requires them to issue new debt. Show the impact of this on BOTH the market for loanable funds and the market for government debt. What happens to the real interest rate in each market? The quantity of loanable funds? The quantity of US debt.
Answer: This causes an increase in the demand for government debt since the government issues more debt. This causes an increase in the real interest rate paid on government debt. The result is an increase in the quantity of government debt. The result is a decrease in the supply of loanable funds (since people are putting their money into government debt instead of the bank). The result is an increase in the real interest paid on bank deposits, but a decrease in the quantity.
https://youtu.be/jCB4PgQeTdM
External Resources
Khan Academy: Loanable Funds Market
