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Suggested answers to problem set 3 of econ 325 money and banking course, along with explanations of concepts related to interest rate determination, saving supply curve, and the relationship between private saving and government deficits. It also discusses the impact of the fed selling bonds on interest rates and the relationship between interest rates and economic booms or recessions.
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Note: these are only suggested answers to make sure you're on the right track. Expand upon them as necessary from your class notes and your book.
I. Definitions On your own. See your class notes and your book.
II. Short-Answer Questions/Essays/Calculations Interest Rate Determination
Earnings rise over a person's lifetime, falling after retirement. Desired consumption is much smoother than income. As a result, individuals want to borrow early in their working lives, save during middle age, and dissave in retirement.
(i) Substitution Effect. As r decreases, saving falls through the substitution effect. Lower r means the price of current consumption falls so current consumption rises and saving falls (substitute out of the more expensive good into the relatively less expensive good).
(ii) Income Effect. As r decreases, saving rises through the income effect. For a net saver, a fall in r means a fall in real income, leading to decreased consumption in both periods (assuming consumption is a normal good) and thus increased saving in period one (from the lower C 1 ). Overall, the effect of a decrease in r for a saver is ambiguous (SE and IE work in opposite directions). Note that we get an upward sloping saving supply curve as long as the Substitution Effect is bigger than the Income Effect.
For a net borrower, the substitution effect stays the same. The income effect indicates decreased saving due to the following: the decrease in r raises real income since the individual must pay less interest on all borrowed funds. This in turn leads to increased consumption in both periods and thus lower saving in period one. Therefore, for a net borrower, the SE and IE work in the same direction: a decrease in r leads to lower saving (giving us an upward sloping saving supply curve).
investment is not crowded out by the government’s activities.
In the saving-investment framework, when the economy booms, both curves shift to the right. Thus, the change in the equilibirum interest rate depends on the sensitivity of the curves to changes in income (similar answer to the loanable funds framework).
The liquidity preference framework unambiguously shows that the interest rate is procyclical. When the economy booms, the demand for money increases and the nominal interest rate rises. When the economy enters a recession, the demand for money falls, and the nominal interest rate decreases.
Hint - a graph is often worth a thousand words.
For U.S. data see figure in the chapter “Evidence on Business Cycles and Interest Rates.”