Three students have each saved $1,000. Each has an investment opportunity in whi
ID: 1144618 • Letter: T
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: Return Student (Percent) Sam Andrew 4 15 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. Money a Year Later (Dollars) Student Sam Andrew Beth 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. A student would choose to be a borrower in this market if his or her expected rate of return is than r.Explanation / Answer
When the interest rates are different, each will have a different amount of money next year. Sam will have 1000 x (1+ 4%) = 1040. Andrew will have 1000 x (1 + 7%) = 1070 and so Beth will have 1000 x (1 + 15%) = 1150.
Only when the expected rate of return is greater than market rate of r, a student will borrow because then it is profitable to borrow. If the rate of return is less than the market rate, it will not be able to earn enough to pay the interest and repay the borrowed money. Then it will choose to become a lender.
When interest rate is 6 percent, Sam becomes a lender and so quantity supplied is $1000. The other two students are now borrowers so quantity demanded is $2000.
When interest rate is 12 percent, Sam and Andrew become lenders and so quantity supplied is $2000. Beth is now the only borrower so quantity demanded is $1000.
When the market is in equilibrium, the interest rate is 7 percent. Sam turns lender and Beth turns borrower while Andrew will use his own funds to invest.
At the market rate of 7 percent, Sam is a lender and so he will have 1000 x (1+ 7%) = 1070. Andrew will be earning $1000 x (1 + 7%) = 1070. Beth have borrowed 1000 and so with an expected rate of return of 15 percent, she earns 2000 x ( 1 + 15%) = 2300. She repays the loan at 7 percent interest which is 1070. Hence she has a total of 2300 – 1070 = $1230
No one is worse off because all of them have earned more. So it is false.
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