Three students have each saved $1,000. Each has an investment opportunity in whi
ID: 1201611 • 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: 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. 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
(a) Money a year later = Investment x (1 + Return)
Harry: $1000 x 1.05 = $1050
Ron: $1000 x 1.08 = $1080
Hermione: $1000 x 1.2 = $1200
(b) A student will be a borrower if her expected return is HIGHER than r.
(c) r = 7%
Harry's return is lower than 7%, so he will lend $1000.
Ron and Hermione each has a return higher than 7%, so they will borrow from Harry (Together they will borrow $1000).
Loanable funds supplied = $1000 (Ron) + $1000 (Hermione) + $1000 (supplied by Harry) = $3000
Loanable funds demanded = $1000 (by Ron & Hermione)
(d) Interest rate = 10%
Both Harry and Ron will be Lenders and Hermione will be Borrower.
Quantity demanded = $1000 (by Hermione)
Quantity supplied = $1000 (Harry) + $1000 (Ron) = $2000
(e) At interest rate of 8%, there is equilibrium. At this interest rate, Hermion will borrow and Harry will lend.
(f) After 1 year:
Harry will lend $1000 and earn at 8%, $80.
Net money = $(1000 + 80) = $1080.
Ron will be indifferent. He can borrow or lend at 8% and get return $80.
Net money = $1080.
Hermone will borrow $1000 at 8% and pay $80. Her total return = $1000 x 20% = $200. Her net return = $(200 - 80) = $120.
Net money = $1000 + $120 = $1120
(g) FALSE
Harry is better off ($1080 > $1050).
Ron is indifferent.
Hermione is worse off ($1120 < $1200).
So, Borrower is worse off & Lender is better off.
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