Question

Q.1.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:

Harry              5 percent

Ron                 8 percent

Hermione        20 percent

a. If borrowing and lending is prohibited, so each student uses only his or her saving to finance his or her own investment project, how much will each student have a year later when the project pays its return? [0.5 Marks]

b. Now suppose their school opens up a market for loanable funds in which students can borrow and lend among themselves at an interest rate r. What would determine whether a student would choose to be a borrower or lender in this market? [0.5 Marks]

c. Among these three students, what would be the quantity of loanable funds supplied and quantity demanded at an interest rate of 7 percent? At 10 percent? [0.5 Marks]

d. At what interest rate would the loanable funds market among these three students be in equilibrium? At this interest rate, which student(s) would borrow, and which student(s) would lend? [0.5 Marks]

e. At the equilibrium interest rate, how much does each student have a year later after the investment projects pay their return and loans have been repaid? Compare your answers to those you gave in part (a). Who benefits from the existence of the loanable funds market—the borrowers or the lenders? Is anyone worse off? [0.5 Marks] [Graph-0.5 Marks]

Answer 1

When the students are investing only their saving then the amount they will have after one year

	Return	Amount
Harry	5%	$1000*1.05 = $ 1,050
Ron	8%	$1,000*1.08 = $ 1,080
Hermione	20%	$1,000*1.20 = $ 1,200

B. Each student would compare their rate of return on his or her project. If the expected return is greater they will borrow. If the students have expected return less than they will lend.

C. Harry has expected return of 5%. So he will lend at 7%. While Ron and Hermione will be borrowing.

Quantity of loadable fund supplied = $ 1,000

Quantity of fund demanded = $ 2,000

. When rate is 10%

Harry and Ron will supply fund while Hermione will demand fund.

Quantity of fund supplied = $ 2,000

Quantity of fund demanded = $ 1,000

D. At a rate of 8% the market will be at equilibrium. At this rate Harry will supply fund

Ron will be indifferent so he won't supply or demand fund

Hermione will be demanding fund from the market.

E. At equilibrium interest rate

		Return
Harry	$ 1,000(1+0.08)	$ 1,080	Better off
Ron	$ 1,000(1+0.08)	$ 1,080	No change
Hermione	$2000*1.20-$1000*1.08	$ 1,320	Better off

Both borrower and lender are better off.

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