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BUSI 101
Answer Guide 3
Chapter 8: Saving, Investment, and the Financial System
This Assignment is a Multiple Choice Assignment
Marks: 1 mark per question.
1. Answer: 3
When bond buyers perceive that the probability of default is high, they demand a higher interest rate to
compensate for this risk. Because the Canadian government is considered a safe credit risk, federal
government bonds tend to pay low interest rates (therefore, Option (2) is incorrect). Provincial
governments also issue bonds, but because the provincially-issued bonds are considered to be a greater
credit risk than federally-issued bonds, they pay a higher rate of interest than federal government bonds
(therefore, Option (4) is incorrect). Bonds issued by a large and mature corporation, such as Coca-Cola,
would be considered lower credit risk than bonds from a software company that operates out of a garage
(therefore, Option (1) is incorrect). Corporate bonds also tend to pay higher interest rates compared to
government bonds. In summary, financially shaky corporations such as this software company will pay
considerably higher interest rates than governments of any level and mature and stable corporations
(therefore, Option (3) is correct).
2. Answer: 4
Option (4) is correct as the sale of stock to raise money is called equity finance, while the sale of bonds is
called debt finance. All other options are incorrect.
3. Answer: 4
When you set up a business, you may need to purchase a building, computers, desks, chairs, and filing
cabinets. To an economist, each of these items is a type of investment.
4. Answer: 1
Option (1) is correct. When a government spends less than it receives in tax revenue, the excess is called
the budget surplus. However, when a government spends more than it receives in tax revenue, the
shortfall is called the government’s budget deficit – therefore, Option (2) is incorrect. Option (4) is
incorrect because a balance budget means that tax revenue is equal to spending, so neither a surplus or a
deficit exists. Option (3) is incorrect because the definition of default is a failure to pay interest and/or
principal on a loan. In this case, the government is not repaying a loan, but is collecting and spending tax
revenue.
5. Answer: 4
Option (4) is an example of a financial intermediary, as a mutual fund allows savers to indirectly provide
funds to borrowers. All other options are examples of financial institutions and constituents [Options (1)
and (3)] found within financial markets, where savers can directly provide funds to borrowers.
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BUSI 101 – Answer Guide 3 Page 2 of 4
6. Answer: 2
When a government reduces national saving by running a budget deficit (decreasing the supply of
loanable funds), the interest rate rises, and investment falls. The fall in investment because of government
borrowing is called crowding out – Option (2) is correct. In other words, when the government borrows to
finance its budget deficit, it crowds out private borrowers who are trying to finance investment.
7. Answer: 3
Option (3) is false as corporate bonds tend to pay higher rates of interest than provincial bonds because
corporate revenues are likely to be more volatile than provincial tax revenues. All other options are true.
8. Answer: 2
In the equation given, saving equals private saving (Y − T − C) plus public saving (T − G), thus Option (2) is
correct. Private saving is the amount of income that households have left after paying their taxes and
paying for their consumption. Public saving is the amount of tax revenue that the government has left
after paying for its spending.
9. Answer: 1
Stocks represent a claim to partial ownership in a firm; bonds represent a certificate of indebtedness, thus
Option (3) is incorrect. Option (4) is incorrect as stocks raise money through equity financing whereas
bonds raise money through debt financing. If a company is very profitable, its shareholders enjoy the
benefits of these profits while its bondholders only get the interest on their bonds. However, if the
company runs into financial difficulty, the bondholders are paid for what they are due before
stockholders receive anything at all. Therefore, compared to bonds, stocks offer the holder both higher
risk and potentially higher return – Option (1) is correct.
10. Answer: 2
Option (2) is correct as Reggie is a saver, he spends less than he earns – his income exceeds his
expenditures. Savers supply their money to the financial systems with the expectation that they will
receive it back in the future with interest earned.
11. Answer: 2
If the government increases the tax on interest income, the supply of loanable funds would decrease,
which will increase the equilibrium interest rate and lower the equilibrium quantity of loanable funds.
Thus, if a change in the tax law encouraged lower saving, the result would be higher interest rates and
lower investment – Option (2) is correct.
12. Answer: 3
Option (3) is correct because an increase in budget deficit, which occurs when the government spends
more than it receives in tax revenue, will lower national saving. This results in the supply for loanable
funds to decrease and the equilibrium interest rate to rise. Thus, the supply curve will shift left – Option
(4) is incorrect for this reason. Options (1) and (2) are also incorrect because the demand for loanable
funds will not change from a budget deficit because the budget deficit does not influence the amount that
households and firms want to borrow to invest at any given interest rate.
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BUSI 101 – Answer Guide 3 Page 3 of 4
13. Answer: 2
Option (2) is false because banks and mutual funds are examples of financial intermediaries, which allow
for indirect movement of money from savers to borrowers. Financial markets are the institutions through
which a person who wants to save can directly supply funds to a person who wants to borrow. For
example, bonds, which are certificates of indebtness, and stocks, which are partial ownership in a firm –
thus Option (3) is true. Therefore, financial markets serve an important role of linking the present and the
future [Option (1)]. Those who supply loanable funds – savers – do so because they want to convert some
of their current income into future purchasing power. Those who demand loanable funds – borrowers –
do so because they want to invest today in order to have additional capital in the future to produce goods
and services – Option (4) is true.
14. Answer: 1
The interest rate on a bond depends, in part, on its term. Short-term bonds are generally less risky than
long-term bonds because holders of long-term bonds have to wait longer for repayment of principal. If a
holder of a long-term bond needs their money earlier than the distant date of maturity, they have no
choice but to sell the bond to someone else, perhaps at a reduced price. To compensate for this risk,
long-term bonds usually pay higher interest rates than short-term bonds.
15. Answer: 1
The demand for loanable funds comes from those households and/or firms who wish to make
investments – investment is the source of the demand for loanable funds. The real interest rate is the price
of a loan, as it represents the price borrowers pay for loans to lenders who supply their saved funds. Given
that as the interest rate increases, the supply of loanable funds will decrease, representing a negative
relationship between the real interest rate and investment. Option (1) is correct.
16. Answer: 4
The demand for a stock, i.e., its price, reflects people’s perception of the corporation’s future profitability.
Option (4) is correct because the demand for the stock and the price of the stock will both rise as people’s
perception of their new product is optimistic. As demand for the stock increases, it will drive up the price
of the stock.
17. Answer: 1
National saving, also known as saving, is equal to investment, thus Option (1) is correct. Using accounting
identities, S = I, savings (S) and investment (I) must be equal for the economy as a whole. This equilibrium
is achieved via the financial system, taking in savings and investing it.
18. Answer: 3
Public savings is the amount of tax revenue that the government has left after paying for its spending. To
determine the public saving amount for Hyrkania, we can use the following formula:
Public saving =
T −G =$100 − $180 =−$80 billion
Where T represents tax revenue and G represents government purchases.
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BUSI 101 – Answer Guide 3 Page 4 of 4
19. Answer: 2
To determine the saving and investment amount for Hyrkania, we can use either of the following
formulas, keeping in mind that saving (S) is equal to investment (I) for a closed economy, S = I:
S=(Y − T − C ) + (T − G ) =
I= ($700 − $100 − $500) + ($100 − $180) =
$100 + −$80 =
$20 billion
S =I =(Y − C − G ) =$700 − $500 − $180 =$20 billion
Where Y represents GDP, T represents taxes collect from households and transfer payments to
households, C represents consumption, and G represents government purchases. Note above that the two
T variables in the first equation cancel out, giving way to the second equation.
20. Answer: 3
Option (3) is correct. The investment tax credit rewards firms that borrow and invest in new capital; it
would alter investment at any given interest rate, therefore, changing the demand for loanable funds.
Because firms would have an incentive to increase investment at any interest rate, the quantity of
loanable funds demanded would be higher at any interest rate. Thus, the demand curve for loanable
funds would shift to the right. Therefore, Option (1) is incorrect. Options (2) and (4) are incorrect because
the tax credit would not affect the amount that households save at any given interest rate; it would not
affect the supply of loanable funds. Instead, the tax credit would raise interest rates, which would result in
households increasing their savings to earn more interest, thus increasing the quantity of loanable funds
supplied. The change in household behaviour is represented by a movement along the supply cure.
_____
20 Total Marks
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