[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

Review and Practice
SUMMARY
1. The interest rate is determined in the capital market—
also called the loanable funds market. The supply of
loanable funds comes from savings, as some households
and firms spend less than their income. The demand
arises from those households and firms that spend more
than their income.
2. In making a decision to save, people face a trade-off
between current and future consumption. The amount
of extra consumption an individual can obtain in the
future by reducing present consumption is determined
by the real rate of interest.
3. A dollar received in the future is worth less than a dollar
received today. The present discounted value tells us
how much a future dollar amount is worth today. The
present discounted value of a future amount falls when
the rate of interest rises.
4. The real interest rate adjusts to balance supply and
demand in the capital market.
5. The interest rate is an important part of the cost of using
capital. If the interest rate increases, the cost of using
capital increases. Firms’ demands for funds for investment
decrease as they cut back on their purchases of
capital goods.
6. Human capital adds to economic productivity just as
physical capital does. It is developed by education, onthe-job
training, and investments of time and money that
parents make in their children.
KEY TERMS
capital market
loanable funds market
life-cycle saving
interest
principal
time value of money
present discounted value
real rate of interest
nominal rate of interest
aggregate saving
capital goods
human capital
REVIEW QUESTIONS
1. How does a choice to consume in the present determine
the amount of consumption in the future?
2. What is the price of future consumption in terms of
present consumption?
3. For savers, how will the income effect of a higher interest
rate affect current saving? How will the substitution
effect of a higher interest rate affect current savings?
4. What are some of the factors, besides incomes and
interest rates, that affect saving?
5. Describe how students invest time and money to acquire
human capital.
PROBLEMS
1. This chapter focused on how interest rates affect savers.
If an individual is a net debtor (that is, she owes money),
what is the income effect of an increase in interest rates?
Will an increase in the interest rates that she has to pay
induce her to borrow more or borrow less?
2. In the context of the life-cycle model of saving, explain
whether you would expect each of the following situations
to increase or decrease household saving.
(a) More people retire before age 65.
(b) There is an increase in life expectancy.
(c) The government passes a law requiring private
businesses to provide more lucrative pensions.
3. Explain how each of the following changes might affect
people’s saving.
(a) Inheritance taxes are increased.
(b) A government program allows college students to
obtain student loans more easily.
(c) The government promises to assist anyone injured
by natural disasters such as hurricanes, tornadoes,
and earthquakes.
(d) More couples decide against having children.
(e) The economy does far worse than anyone was
expecting in a given year.
4. Economists are fairly certain that a rise in the price of
most goods will cause people to consume less of those
goods, but they are not sure whether a rise in interest
rates will cause people to save more. Use the ideas of
substitution and income effects to explain why economists
are confident of the conclusion in the first case but
not in the second.
REVIEW AND PRACTICE ∂ 207