Question

Three students have each saved $1,000. Each has an investment opportunity in which he or she can invest up to $2,000. Here are the rates of return on the students’ investment projects:

Student	Return
	(Percent)
Lorenzo	8
Sam	13
Teresa	24

Assume borrowing and lending is prohibited, so each student uses only personal saving to finance his or her own investment project.

Complete the following table with how much each student will have a year later when the project pays its return.

Student	Money a Year Later
	(Dollars)
Lorenzo
Sam
Teresa

Now suppose their school opens up a market for loanable funds in which students can borrow and lend among themselves at an interest rate rr.

If a student’s expected rate of return is less than rr, he or she would choose to _______ (borrow or lend?) .

Suppose the interest rate is 10 percent.

Among these three students, the quantity of loanable funds supplied would be $____ , and quantity demanded would be $_____.

Now suppose the interest rate is 15 percent.

Among these three students, the quantity of loanable funds supplied would be $______ , and quantity demanded would be $________.

At an interest rate of ____% , the loanable funds market among these three students would be in equilibrium. At this interest rate, _________ (Teresa, Sam, Sam and Teresa, Lorenzo, Lorenzo and Sam) would want to borrow, and ________ (Lorenzo and Sam, Sam, Teresa, Lorenzo, Sam and Teresa) would want to lend.

Suppose the interest rate is at the equilibrium rate.

Complete the following table with how much each student will have a year later after the investment projects pay their return and loans have been repaid.

Student	Money a Year Later
	(Dollars)
Lorenzo
Sam
Teresa

True or False: Both borrowers and lenders are made better off.

True

False

Answer 1

a) A year later, money in the hands of the students:

Lorenzo : 1000 + 80 = 1080

Sam: 1000 + 130 = 1130

Teresa: 1000 + 240 = 1240

b) If a student’s expected rate of return is less than rr, he or she would choose to lend.

c) Suppose the interest rate is 10 percent.

Among these three students, the quantity of loanable funds supplied would be $1000, and quantity demanded would be $2000.

d) Now suppose the interest rate is 15 percent.

Among these three students, the quantity of loanable funds supplied would be $2000 , and quantity demanded would be $1000.

At an interest rate of 13% , the loanable funds market among these three students would be in equilibrium. At this interest rate, Teresa  would want to borrow, and Lorenzo would want to lend.

e) Suppose the interest rate is at the equilibrium rate.

Student	Money a Year Later
(Dollars)
Lorenzo	1130
Sam	1130
Teresa	1350

True or False: Both borrowers and lenders are made better off.

True

Both Lorenzo and Teresa are mad ebetter off. Lorenzo has earned $50 more (1130 - 1080 = 50). Teresa has earned $110 more (1350 - 1240 = 110). So both are better off.

For Sam, it does not make any difference as his expected rate = rr. He will neither borrow, nor lend, but use his own money and invest and earn 13% in return.