ECON 121 Discussion: Week 11

Slides available here:

All discussion slides here:

Midterm 2

Midterm #2 will be this Friday (April 4th) in class

  • Midterm #2 will cover all chapters and Dr. Pieper’s material we’ve covered since Midterm #1

  • Come to office hours with any questions and for help with studying!


What you need to bring (and not bring) to the exam

  • Bring a pencil and an eraser ✏️

  • Bring your ID number (use your ID card if you don’t have it memorized 🪪)

  • No calculators, phones, or pens


I do not know what the format of the exam will be, but definitely expect multiple choice questions similar to Midterm #1 and maybe short answer questions

Please feel free to ask Dr. Pieper directly if you have questions about the exam! He likes questions and your classmates will love you!

Today’s Plan

  1. Midterm #2 study session
  2. Open floor: any questions you have!



Note: the practice problems in this week’s (and in previous weeks’) slides are Achieve-style questions but may not look exactly like the questions that will be on exams. I’ve chosen questions and topics randomly: the topics covered here and their proportions are not reflective of how the exam will look.

I also cannot cover all topics each week. You are responsible for making sure you know all material from lecture that could be tested.

Midterm #2 Practice Problems

Practice Problem #1

Think about the liquidity and riskiness of financial assets. Which of the below statements is true?

  1. Bonds are both more risky and more liquid than stocks because bonds pay interest while stocks do not
  2. Deposit accounts are more liquid than bonds but are riskier than bonds because banks can go out of business
  3. Bonds are both less risky and less liquid than stocks because the value of a bond isn’t as volatile as the value of a share of stock and shares of stock are easier to sell
  4. Stocks are riskier than deposit accounts because share prices are volatile and are more liquid because shares of stock are easy to sell on the stock market

Practice Problem #1

Think about the liquidity and riskiness of financial assets. Which of the below statements is true?

  1. Bonds are both more risky and more liquid than stocks because bonds pay interest while stocks do not
  2. Deposit accounts are more liquid than bonds but are riskier than bonds because banks can go out of business
  3. Bonds are both less risky and less liquid than stocks because the value of a bond isn’t as volatile as the value of a share of stock and bonds and shares of stock are easier to sell
  4. Stocks are riskier than deposit accounts because share prices are volatile and are more liquid because shares of stock are easy to sell on the stock market

Answer

The other statements are wrong for a few reasons:

  1. Bonds are less risky than stocks because they’re “IOU”s and come with guaranteed interest payments. Stocks are usually more liquid than bonds because it’s easy to sell shares on the stock market.
  2. Deposit accounts aren’t riskier than bonds: bank failures are infrequent and most deposit accounts are at least partially insured by the government.
  3. Stocks aren’t more liquid than deposit accounts: you can very easily pull cash out of deposit accounts.

Practice Problem #2

Last year workers in the small country of Macrogascar worked 1 million hours and produced 100,000 units of goods in the country’s 200 factories. This year Macrogascar’s workers worked the same amount in the same number of factories but produced 150,000 units of goods. Which of the below best describes what happened in Macrogascar?

  1. Foreign investment into Macrogascar made its economy more efficient
  2. New technology made Macrogascar’s factories more efficient
  3. Workers’ productivity increased because of better training or education
  4. Macrogascar’s total factor productivity increased

Practice Problem #2

Last year workers in the small country of Macrogascar worked 1 million hours and produced 100,000 units of goods in the country’s 200 factories. This year Macrogascar’s workers worked the same amount in the same number of factories but produced 150,000 units of goods. Which of the below best describes what happened in Macrogascar?

  1. Foreign investment into Macrogascar made its economy more efficient
  2. New technology made Macrogascar’s factories more efficient
  3. Workers’ productivity increased because of better training or education
  4. Macrogascar’s total factor productivity increased

Answer

Remember that factors of production fall into two broad categories: labor and capital. Macrogascar produced more output with the same amount of labor (hours worked) and capital (factories), so its TFP increased.

The question setup doesn’t say why! We can’t say if this was because of technology or improvements in human capital. We also don’t know that Macrogascar had foreign investment at all.

Practice Problem #3

Which of the below is an example of a benefit of financial intermediaries we covered in class?

  1. Banks usually have suckers at the counter when you visit
  2. Many financial intermediaries will charge fees for services and for managing financial assets like mutual funds
  3. Stock brokers at investment firms can inform you about riskier investment opportunities that come with potentially higher returns
  4. Specialists at financial intermediaries, like advisors and loan officers, can offer advice for individual investors and businesses and help draft legal documents

Practice Problem #3

Which of the below is an example of a benefit of financial intermediaries we covered in class?

  1. Banks usually have suckers at the counter when you visit
  2. Many financial intermediaries will charge fees for services and for managing financial assets like mutual funds
  3. Stock brokers at investment firms can inform you about riskier investment opportunities that come with potentially higher returns
  4. Specialists at financial intermediaries, like advisors and loan officers, can offer advice for individual investors and businesses and help draft legal documents

Answer

This is an example of reducing transaction costs: specialists perform roles that make it cheaper and easier for investors to find good investment opportunities or for businesses taking out loans to draft loan agreements (versus doing it all yourself).

Practice Problem #4

In the investment-savings model, which of the following is not a source of funding for investment?

  1. Private savings
  2. Government savings
  3. Any portions of sales income that businesses use to fund investment spending
  4. Foreign investment from net capital inflows

Practice Problem #4

In the investment-savings model, which of the following is not a source of funding for investment?

  1. Private savings
  2. Government savings
  3. Any portions of sales income that businesses use to fund investment spending
  4. Foreign investment from net capital inflows

Answer

The investment-savings model relies on the investment-savings identity:

\[I = S_{\text{Private}} + S_{\text{Government}} + NCI\]

There are three sources of funding for investment in this model: private savings, government savings, and any foreign investment (if the economy has a positive NCI).

Practice Problem #5

Consumers’ marginal propensity to save declines from 0.7 to 0.5. Will this increase or decrease GDP across time? Why?

  1. Decrease, because this will lower the GDP multiplier
  2. Neither, the GDP equation does not include savings
  3. Increase, because this will increase the GDP multiplier
  4. Decrease, because less private saving means less investment spending

Practice Problem #5

Consumers’ marginal propensity to save declines from 0.7 to 0.5. Will this increase or decrease GDP across time? Why?

  1. Decrease, because this will lower the GDP multiplier
  2. Neither, the GDP equation does not include savings
  3. Increase, because this will increase the GDP multiplier
  4. Decrease, because less private saving means less investment spending

Answer

Remember the GDP multiplier: \(\frac{1}{1 - MPC} \equiv \frac{1}{MPS}\). A lower marginal propensity to save means consumers have a higher propensity to consume so the GDP multiplier will be larger. The GDP multiplier works because someone’s expenses is someone else’s income, so more consumption means the effect of the multiplier is larger.

You can plug in the numbers to check that the GDP multiplier will increase: \(\frac{1}{0.7} < \frac{1}{0.5}\). Or analytically, \(\frac{1}{x}\) will be larger for smaller \(x\).

Practice Problem #6

The country of Macronesia has a negative net capital inflow (a.k.a. a net capital outflow). Which of the following must be true?

  1. \(X > IM\): Macronesia is running a trade surplus and funds are flowing out of the country
  2. \(X = IM\): Macronesia’s trade balance is even and so it has more money for domestic investment
  3. \(X > IM\): Macronesia is running a trade deficit and funds are flowing into the country to buy Macronesian assets
  4. \(X < IM\): Macronesia is running a trade deficit and must borrow from other countries to finance the deficit

Practice Problem #6

The country of Macronesia has a negative net capital inflow (a.k.a. a net capital outflow). Which of the following must be true?

  1. \(X > IM\): Macronesia is running a trade surplus and funds are flowing out of the country
  2. \(X = IM\): Macronesia’s trade balance is even and so it has more money for domestic investment
  3. \(X > IM\): Macronesia is running a trade deficit and funds are flowing into the country
  4. \(X < IM\): Macronesia is running a trade deficit and must borrow from other countries to finance the deficit

Answer

A net capital outflow occurs when a country has a trade surplus (when it’s importing less than it’s exporting). This surplus allows Macronesians to invest in foreign economies, so more funds are flowing out of the Macronesian economy than are flowing in.

Practice Problem #7

Which scenario below describes a country most likely to experience an increase in economic growth?

  1. Businesses in Macrolasia, which rely heavily on physical capital to produce goods, invest in even more physical capital
  2. The government of Macrostan invests in programs that make college more accessible and affordable for its citizens
  3. The People’s Republic of Macro reduces government spending on research and development projects
  4. The birth rate in the United Macro Provinces recently increased by 5 percent

Practice Problem #7

Which scenario below describes a country most likely to experience an increase in economic growth?

  1. Businesses in Macrolasia, which rely heavily on physical capital to produce goods, invest in even more physical capital
  2. The government of Macrostan invests in programs that make college more accessible and affordable for its citizens
  3. The People’s Republic of Macro reduces government spending on research and development projects
  4. The birth rate in the United Macro Provinces recently increased by 5 percent

Answer

Macrostan is likely to experience increase economic growth because investing in education will increase the economy’s human capital, which will increase productivity.

Macrolasia will probably see diminishing returns to investments in physical capital investment since it’s already using a lot. The People’s Republic of Macro might miss out on technology improvements that would increase productivity if it cuts R&D spending. A higher population in the United Macro Provinces doesn’t automatically translate to higher economic growth.

Practice Problem #8

If government purchases of goods and services (G) equals 100, government transfer payments (TR) equals 50, and government tax revenue (T) equals 80, then government saving equals

  1. -20
  2. -70
  3. 30
  4. 70

Practice Problem #8

If government purchases of goods and services (G) equals 100, government transfer payments (TR) equals 50, and government tax revenue (T) equals 80, then government saving equals

  1. -20
  2. -70
  3. 30
  4. 70

Answer

(This question is from Dr. Pieper’s Loanable Funds Practice Questions PDF on Blackboard)

Just like with normal people, how much the government saves is the difference between the money it collects and the money it spends. A government collects money (taxes) and spends money (gov’t spending and transfer payments). So government savings here is:

\[ \begin{align} \text{Gov't Saving} &= T - G - TR \\ &= 80 - 100 - 50 = -70 \end{align} \]

Practice Problem #9

Which of the following would lead to an increase in the supply of loanable funds?

  1. Individual savers expect a recession and high unemployment in the near future
  2. Businesses expect a recession in the near future and begin reducing spending on research and development projects
  3. Business confidence increases and companies feel safer about taking on new investment projects
  4. The government runs a budget deficit and must borrow to make up the difference between its revenue and spending

Practice Problem #9

Which of the following would lead to an increase in the supply of loanable funds?

  1. Individual savers expect a recession and high unemployment in the near future
  2. Businesses expect a recession in the near future and begin reducing spending on research and development projects
  3. Business confidence increases and companies feel safer about taking on new investment projects
  4. The government runs a budget deficit and must borrow to make up the difference between its revenue and spending

Answer

Individuals who expect unemployment in the near future will spend less and save more today in anticipation of job losses. Higher savings increases the supply of loanable funds.

The other options describe factors that would change the demand for loanable funds.