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:

Student	Return
	(Percent)
Carlos	4
Felix	7
Janet	15

Assume borrowing and lending is prohibited, so each student uses only personal saving to finance his or her own investment project.

Now suppose their school opens up a market for loanable funds in which students can borrow and lend among themselves at an interest rate rr.

A student would choose to be a lender in this market if his or her expected rate of return is   than rr.

Suppose the interest rate is 6 percent.

Among these three students, the quantity of loanable funds supplied would be

, and quantity demanded would be

.

Now suppose the interest rate is 12 percent.

Among these three students, the quantity of loanable funds supplied would be

, and quantity demanded would be

.At an interest rate of

, the loanable funds market among these three students would be in equilibrium. At this interest rate,   would want to borrow, and   would want to lend.

Suppose the interest rate is at the equilibrium rate.

True or False: Only lenders are made better off, and borrowers are made worse off.

True

False

Answer 1

When the interest rates are different, each will have a different amount of money next year.

Carlos will have 1000 x (1+ 4%) = 1040.

Felix will have 1000 x (1 + 7%) = 1070 and so

Janet will have 1000 x (1 + 15%) = 1150.

Only when the expected return rate is higher than r's market rate will a student borrow because then borrowing is profitable. If the return rate is lower than the market rate, it can not earn enough to pay the interest and repay the borrowed money. Then it's going to choose to be a lender.

Carlos becomes a borrower when the interest rate is 6 percent, and so the quantity supplied is $1,000. The other two students are now lenders, and they need $2000 in quantity.

When interest rate is 12 percent, Carlos and Felix become lenders and so quantity supplied is $2000. Janet is now the only borrower so quantity demanded is $1000.

When the market is in equilibrium, the interest rate is 7 percent. Carlos and Felix turns lender and Janet turns borrower while Felix will use his own funds to invest.

At the market rate of 7 percent, Carlos is a lender and so he will have 1000 x (1+ 7%) = 1070. Felix will be earning $1000 x (1 + 7%) = 1070. Janet 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's getting worse because they've all earned more. Both borrowers and lenders are doing good. So it’s a false statement.