Microeconomics, 7e (Perloff)

Chapter 16 Interest Rates, Investments, and Capital Markets

16.1 Comparing Money Today to Money in the Future

1) Suppose a person has a discount rate of zero. This implies she

A) places no value on the future.
B) places no value on the present.
C) values the present and the future equally.
D) would not lend money at any positive interest rate.
Answer: C
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

2) If an individual wins a multimillion dollar lottery and chooses to receive annual payments
equaling the total prize, this person has a
A) relatively low discount rate.
B) relatively high discount rate.
C) discount rate of zero.
D) It is impossible to tell.
Answer: C
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

3) Suppose two people with the same level of income and wealth have different discount
rates. Joe has a very high discount rate and Jim has a very low discount rate. Which one of
the following is TRUE?
A) Joe is more likely to borrow than Jim.
B) Joe is less likely to borrow than Jim.
C) Joe and Jim will borrow the same amount.
D) Neither Joe nor Jim would be borrowers.
Answer: A
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

4) If inflation is 10% and the nominal interest rate equals 16.6% the real interest rate is
equal to
A) 6.6%.
B) 6%.
C) -6.6%.
D) zero.
Answer: B
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

5) Interest rates are positive mainly because

A) of inflation.
B) people tend to prefer the present to the future.
C) people tend to prefer the future to the present.
D) bankers are greedy.
Answer: B
1
Copyright © 2015 Pearson Education, Inc.
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

6) If you place $100 in a bank account that pays 6% at the end of each year, and you leave
your $100 and all your interest in the bank, how much will you have in the bank at the end
of 7 years with annual compounding?

B) 7 ∗ (106)
A) (106)7

C) 100 ∗ (1.60)7
D) 100 ∗ (1.06)7
Answer: D
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

7) If you invest $500 today, and the value one year from today is $1000, then the annual
interest rate must be
A) 10%.
B) 50%.
C) 100%.
D) 200%.
Answer: C
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

8) For a given rate of interest, the total interest you receive from lending money
A) increases with the frequency of compounding.
B) decreases with the frequency of compounding.
C) is independent of the frequency of compounding.
D) is greatest when there is no compounding.
Answer: A
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

2
Copyright © 2015 Pearson Education, Inc.
9) If the interest rate is 10%, then $1 received one year from now is worth how much
today?
A) $1.10
B) $1.00
C) $0.91
D) $0.90
Answer: C
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

10) If the interest rate is 10%, then $1 today is worth how much one year from now?
A) $1.10
B) $1.00
C) $0.91
D) $0.90
Answer: A
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

11) You place $100 in a bank account that pays 8%. If you remove the interest you receive
each year you can turn your stock into a flow of
A) $108 per year.
B) $100 per year.
C) $80 per year.
D) $8 per year.
Answer: D
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

12) You can put your $100 in Bank A that pays 8% at the end of the year. You can also put
your $100 in Bank B that pays 4% at the end of six months and then 4% again at the end of
the year. You will keep your $100 and all interest in the bank. At the end of the year
A) the total will be the same at both banks.
B) the total at Bank A will be greater.
C) the total at Bank B will be greater.
D) the total could be larger at either bank.
Answer: C
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

3
Copyright © 2015 Pearson Education, Inc.
13) You invest an amount today for four years that pays 6% annually. The bank compounds
annually. At the end of the four years you will have $150. What amount must you invest
today?
A) $148.81
B) $138.81
C) $128.81
D) $118.81
Answer: D
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

14) If savers require a 2% return and inflation is expected to be 3%, what approximate rate
will banks offer savers?
A) 1%
B) 3.2%
C) 5%
D) 6%
Answer: C
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

15) If your bank pays you 6% interest on a savings account and inflation is 2%, your
approximate real rate of interest is
A) 2%.
B) 4%.
C) 8%.
D) 12%.
Answer: B
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

16) If inflation turns out to be higher than was anticipated,

A) debtors are helped.
B) debtors are hurt.
C) debtors are neither helped nor hurt.
D) the effect on debtors cannot be predicted.
Answer: A
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

4
Copyright © 2015 Pearson Education, Inc.
17) Four banks are offering the same interest rate of 4%. Where do you invest?
A) Bank A compounds interest on a yearly basis.
B) Bank B compounds interest on a monthly basis.
C) Bank C compounds interest on a daily basis.
D) I am indifferent between banks.
Answer: C
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

18) If inflation turns out to be higher than was anticipated, debtors are helped because
A) the real present value of their payments increases.
B) the real present value of their payments decreases.
C) the nominal present value of their payments increases.
D) the nominal present value of their payments decreases.
Answer: B
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

19) If you agree to a long-term loan at a specified nominal rate of interest and inflation
turns out to be higher than was anticipated,
A) the nominal rate of interest falls.
B) the nominal rate of interest rises.
C) the real rate of interest falls.
D) the real rate of interest rises.
Answer: C
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

20) As the interest rate rises, the present value of a given perpetual stream of income
A) increases.
B) decreases.
C) does not change.
D) approaches infinity.
Answer: B
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

5
Copyright © 2015 Pearson Education, Inc.
21) As the interest rate increases, the present value of a future payment
A) increases.
B) decreases.
C) does not change.
D) approaches infinity.
Answer: B
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

22) If an asset has a future value of $120, a present value of $30, and an interest rate of
4%, how many periods of compounding are there?
A) 45 periods
B) 35 periods
C) 28 periods
D) 100 periods
Answer: B
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

23) If an asset has a present value of $50 and appreciates at an interest rate of 4%, what is
the asset's future value in 47 compounding periods?
A) Approximately $400
B) Approximately $316
C) Approximately $137
D) Approximately $1143
Answer: B
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

24) Individuals who lease a new car

A) have a higher discount rate than those who buy.
B) have a lower discount rate than those who buy.
C) have the same discount rate as those who buy.
D) behave irrationally and are taken advantage of by car companies.
Answer: A
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

6
Copyright © 2015 Pearson Education, Inc.
25) You won the "$1,000 per year forever" lottery. You decided to convert such prize into a
lump sum payment. The interest rate is 2% per year. How much is this lump sum payment ?
A) $25,000
B) $1,000
C) $50,000
D) $365,000
Answer: C
Section: Comparing Money Today to Money in the Future
Question Status: New
AACSB: Analytic thinking

26) A firm has to decide between two projects that cost $10,000 each. Project A will
provide a revenue $10,700 one year from now, while Project B will provide a revenue of
$12,200 two years from now. The interest rate is 10% per year. This firm
A) chooses project A.
B) chooses project B.
C) rejects both projects.
D) is indifferent between projects A and B.
Answer: B
Section: Comparing Money Today to Money in the Future
Question Status: New
AACSB: Analytic thinking

27) A firm has to choose between projects X and Y. Project X's internal rate of return is
positive. If the cash flow of project Y is discounted at project X's internal rate of return, this
firm will
A) choose project X if the net present value of project Y is positive.
B) choose project X if the net present value of project Y is negative.
C) choose project Y if the net present value of project Y is positive.
D) choose project X regardless of the net present value of project Y.
Answer: B
Section: Comparing Money Today to Money in the Future
Question Status: New
AACSB: Analytic thinking

For the following, please answer "True" or "False" and explain why.

28) Suppose $100 is deposited in a bank account paying 5% compounded annually. If the
interest earned is X after 5 years, then the interest earned will be 2X after 10 years.
Answer: False. Because of compounding, the balance on which interest is earned grows
over time. Thus, the interest earned in years 6 to 10 will exceed the interest earned in
years 1 to 5.
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

7
Copyright © 2015 Pearson Education, Inc.
29) If the interest rate is positive, the future value of an interest bearing investment is

Answer: True. FV = PV ∗ (1 + i)t. If the interest rate is positive, the future value will
always larger than the present value.

always be greater than the present value.

Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

30) Interest rates are positive because inflation makes purchases more expensive in the
future than today.
Answer: False. Even if inflation were zero, interest rates would be positive since people
prefer present consumption to future consumption.
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

31) Jerry wishes to retire in 5 years with $1 million in his bank account. If the account pays
4% and his current balance is $500,000, how much must he deposit at the beginning of
each of the next five years for his wish to come true? The amount must be the same each
year.
Answer: His current accumulation will grow to $608,326.45, leaving him $391,673.55
short. To get this, he will save X at the beginning of each of the next five years so that
$391,673.55 = X[(1.04) + (1.04)2 + (1.04)3 + (1.04)4 + (1.04)5] = X[5.63292]. X =
$69,532.95.
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

32) In an economy with no inflation, explain why interest rates are positive.
Answer: Because most people prefer consumption today relative to consumption
tomorrow, they must be compensated for delaying consumption. Interest is the
compensation for the delay in consumption.
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

33) A state lottery has a Million Dollar Lottery game that pays $1,000 a week for life.
Assuming a 6% nominal rate of interest and generously assuming an infinite lifetime, can
this game be called a "Million Dollar Lottery"?
Answer: Assuming that the payments last forever, the present value of the payments is
roughly 52,000/.06 = $866,667. Not really a million dollars.
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

34) A major corporation hires high school students on a part-time basis. It offers a reward
of $5,000 to any of its high school seniors who graduate college in four years. What is the
present value of that reward to a student who just finished her junior year of high school,
assuming a nominal rate of interest of 8%?
Answer: 5000/(1.08)5 = $3,402.92
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

35) You sign a contract to pay $1000 next year for the refrigerator you bought today. The
rate of inflation is 10% and the real interest rate is 7%. Alternatively, you could pay $875
8
Copyright © 2015 Pearson Education, Inc.
Answer: 1000/[(1 + .1) ∗ (1 + .07)] = $849.60. This is the real present value of the $1000
today. What should you do to save the most money?

payment next year. Thus, you should pay next year and not today in order to save the most
money.
Section: Comparing Money Today to Money in the Future
Question Status: Old
AACSB: Analytic thinking

16.2 Choices over Time

1) A firm should make an investment if the expected return is greater than

A) the marginal cost of the investment.
B) the fixed cost of the investment.
C) the opportunity cost of the investment.
D) the expected rate of inflation.
Answer: C
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

2) The Net Present Value approach to investment results in an investment being

undertaken only if
A) its net present value is positive.
B) its net present value is zero.
C) it has positive cash flow.
D) its internal rate of return equals the rate of interest.
Answer: A
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

3) Suppose a new cost-saving device will generate $1,000 net savings per year to a firm.
The device costs $10,000. Should the firm purchase the device?
A) Definitely.
B) Absolutely not.
C) The firm is indifferent between buying the device and not.
D) More information is required to answer.
Answer: D
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

9
Copyright © 2015 Pearson Education, Inc.
4) Suppose a new cost-saving device will forever generate $1,000 net savings per year to a
firm. The device costs $10,000. Using the Internal Rate of Return approach, the firm will
make the investment
A) definitely.
B) definitely not.
C) if the interest rate exceeds 10%.
D) if the interest rate is less than 10%.
Answer: D
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

5) In using the Internal Rate of Return approach, one must first calculate the discount rate
on the investment that makes
A) the net present value equal zero.
B) the interest rate equal zero.
C) the interest rate equal the discount rate.
D) the first year's return positive.
Answer: A
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

6) Using the Internal Rate of Return approach to investment, one would undertake an
investment if the internal rate of return
A) equals zero.
B) equals the interest rate.
C) exceeds the interest rate.
D) is less than the interest rate.
Answer: C
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

7) To calculate the internal rate of return on a factory that would yield a perpetual future
stream of income, one would divide
A) the annual future payment by the cost of the factory.
B) the sum of the future payments by the cost of the factory.
C) the cost of the factory by the rate of interest.
D) the cost of the factory by the annual future payment.
Answer: A
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

10
Copyright © 2015 Pearson Education, Inc.
8) A bond issuer agrees to pay a stated nominal amount each year. An increase in the
nominal interest rate will cause
A) the price of the bond to fall.
B) the price of the bond to rise.
C) the nominal value of the bond's coupon to rise.
D) the nominal value of the bond's coupon to fall.
Answer: A
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

9) If a bond's coupon adjusts to pay a constant real rate of return, then an increase in
inflation would cause
A) the nominal coupon payment to rise.
B) the nominal coupon payment to fall.
C) the nominal coupon payment to remain unchanged.
D) the bond's price to fluctuate wildly.
Answer: A
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

10) If a firm needs one machine to produce a product, and must replace the machine when
it wears out, then the firm should pick a durability level of the machine that
A) minimizes the expense today.
B) minimizes the present discounted cost of having the machine forever.
C) maximizes the future value of the machine.
D) minimizes the future value of the machine.
Answer: B
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

11
Copyright © 2015 Pearson Education, Inc.
11) At age 40, Joe is considering quitting his job and going back for a college degree. He
needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A
college degree would raise his annual income by $10,000 per year. He will retire at age 70.
His cost of going back to college is
A) 10,000 × .

B) 20,000 × .

C) 30,000 × .

D) 40,000 × .

Answer: D
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

12) At age 40, Joe is considering quitting his job and going back for a college degree. He
needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A
college degree would raise his annual income by $10,000 per year. He will retire at age 70.
His benefit of a degree would be
A) 10,000 × .

B) 10,000 × .

C) 10,000/r.

D) 10,000 × .

Answer: D
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

12
Copyright © 2015 Pearson Education, Inc.
13) At age 40, Joe is considering quitting his job and going back for a college degree. He
needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A
college degree would raise his annual income by $10,000 per year. He will retire at age 70.
If these are real amounts (adjusted for inflation), then the discount rate to be used should
be
A) the nominal rate of interest.
B) the real rate of interest.
C) the rate of inflation.
D) zero.
Answer: B
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

14) At age 40, Joe is considering quitting his job and going back for a college degree. He
needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A
college degree would raise his annual income by $10,000 per year. He will retire at age 70.
From an investment standpoint, Joe will go back full-time if

A) 10,000 × = 40,000 × .

B) 10,000/r > 10,000 × .

C) 10,000 × > 40,000 × .

D) 10,000 × > 40,000 × .

Answer: D
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

15) At age 40, Joe is considering quitting his job and going back for a college degree. He
needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A
college degree would raise his annual income by $10,000 per year. He will retire at age 70.
Which of the following makes it more likely that Joe will decide to go back to college full-
time?
A) The rate of interest increases.
B) The rate of interest decreases.
C) The government enacts mandatory retirement at age 60.
D) Tuition increases.
Answer: B
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

16) At age 40, Joe is considering quitting his job and going back for a college degree. He
needs two more years full-time. Tuition is $10,000 per year. He earns $30,000 per year. A
college degree would raise his annual income by $10,000 per year. He will retire at age 70.
Which of the following makes it less likely that Joe will decide to go back to college full-
time?
13
Copyright © 2015 Pearson Education, Inc.
A) The extra income due to a college degree rises.
B) The rate of interest decreases.
C) The government enacts mandatory retirement at age 60.
D) Tuition decreases.
Answer: C
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

17) Today John says: "I will start working out tomorrow." Yet, as tomorrow arrives he
doesn't. This is an example of
A) time inconsistent preferences.
B) time consistent preferences.
C) exponential discounting.
D) future-biased preferences.
Answer: A
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

18) With respect to events like global warming some economists suggest using falling
discount rates because
A) exponential discounting virtually gives no weight to (large) costs incurred far into the
future.
B) exponential discounting weights (large) costs incurred far into the future heavily.
C) events far in the future do not affect us.
D) we should not care about costs far in the future.
Answer: A
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

19) Assume a baseball player's development in the minor leagues yields -$250,000 per year
for four years. If the player were to have a single big league season and be paid $350,000,
how much revenue would the player need to generate to be considered a positive net
present value project from the point of view of the team owner if the interest rate was 4%?
A) $1.45 million
B) $2.5 million
C) $350,000
D) $250,000
Answer: A
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

20) The question "What are you going to do with that major?" implicitly questions
A) how much you learn in that major.
B) whether the major should be offered on campus.
C) how much the market values the human capital developed in the major.
D) western bias.
Answer: C
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

21) An individual who wants to stop smoking but chooses not to

14
Copyright © 2015 Pearson Education, Inc.
A) reflects future bias.
B) reflects present bias.
C) reflects irrationality.
D) reflects uncontrollable addiction.
Answer: B
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

22) Billy is considering the purchase of a rental house. The house costs $240,000 and it will
generate annual revenues of $15,000 and annual expenses of $3,000. What is the internal
rate of return of this investment?
A) 5%
B) 7.5%
C) 3.75%
D) 24%
Answer: A
Section: Choices Over Time
Question Status: New
AACSB: Analytic thinking

23) Billy is considering the purchase of a rental house. The house costs $240,000 and it will
generate annual revenues of $15,000 and annual expenses of $3,000. Nevertheless, Billy
will need to borrow $240,000 at an interest rate of 7% per year in case he decides to make
this investment. Should Billy purchase this house?
A) No, he will lose money.
B) Yes, his profits will be zero.
C) No, his profits will be positive but close to zero.
D) Yes, he will profit from this investment.
Answer: A
Section: Choices Over Time
Question Status: New
AACSB: Analytic thinking

15
Copyright © 2015 Pearson Education, Inc.
24) Bobby faces two choices. The first is to receive $600 on the spot. The other choice is to
receive $800 a year from now. The interest rate is 5% per year. What could a possible
explanation for Bobby choosing to receive $600 on the spot?
A) Bobby finds that the present value of the $800 a year from now is less than $600.
B) Bobby may have time-inconsistent preferences.
C) Although Bobby chooses $600 on the spot, he is actually indifferent between the two
options.
D) None of the above is correct.
Answer: B
Section: Choices Over Time
Question Status: New
AACSB: Analytic thinking

For the following, please answer "True" or "False" and explain why.

25) A recent purchaser of a bond that agrees to pay an annual nominal amount would hope
that interest rates do not rise.
Answer: True, for two reasons. First, the person is locked into a lower interest rate.
Second, if the person needs to sell the bond, he will incur a loss since at higher interest
rates, bond prices fall.
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

26) An investment is profitable as long as its internal rate of return is equal to the rate of
interest.
Answer: False. Such an investment has a profit of zero. The investment is profitable if the
internal rate of return exceeds the interest rate.
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

27) Explain why a firm may rationally make an investment when its cash flow from the
investment is not positive each year.
Answer: A firm will examine the net present value of the investment to determine if the
investment should be made. The net present value of the cash flow for an investment may
be negative for some years, but when all the years of the investment are considered, if the
net present value of the investment is positive, the investment should be made.
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

16
Copyright © 2015 Pearson Education, Inc.
28) Suppose that your college offers you two payment plans. You may either pay tuition of
$10,000 per year at the beginning of each of the next four years, or pay just $38,000 before
the start of freshman year. If the interest rate is 10%, what would you do? If the interest
rate were 2%, what would you do? Intuitively explain the difference in your answer.
Answer: At 10%, the future stream of tuition payments is worth:

$10,000 ∗ [1 + 1/(1.10) + 1/(1.10)2 + 1/(1.10)3] = $10,000 ∗ [1 + .9091 + .8264 + .7513]

= $34,868

At 2%, the future stream of tuition payments is worth:

$10,000 ∗ [1 + 1/(1.02) + 1/(1.02)2 + 1/(1.02)3] = $10,000 ∗ [1 + .98 + .961 + .9425] =

$38,835

Thus, if the interest rate is 10%, paying each year costs less and is preferred to the up-front
payment of $38,000. If the interest rate is 2%, the up-front payment costs less than paying
each year. Intuitively, compared to 10%, the university's discount is not a good deal, but
compared to 2% it is. Alternatively, when the interest rate is 10%, one can save the
$38,000 instead of paying it up front and come out ahead.
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

29) Suppose that your college offers you two payment plans for your last two years of
college. You may either pay tuition of $20,000 per year at the beginning of each of the next
two years, or pay just $38,000 before the start of freshman year. What would the interest
rate have to be for you to be indifferent between these two deals? Explain.
Answer: One is indifferent when the future stream of tuition payments has a present value
of $38,000.

$20,000 ∗ [1 + 1/(1 + irr)] = $38,000

1/(1 + irr) = 0.9 or irr = 11.11%

If the interest rate is 11.11%, the student can pay the first year's tuition and deposit
$18,000 in a bank account today and withdraw $20,000 at the end of the first year to make
her second payment. If the interest rate exceeds 11.11%, the student can deposit $18,000
today, make the $20,000 payment in Year 2, and still have something left over. If the
interest rate is less than 11.11%, the student is better paying the $38,000 all at once.
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

30) A financial services company offers to pay you $1,000 a year for life in exchange for
$20,000 today. What factors affect your decision to take this offer?
Answer: This policy has an internal rate of return of 1/20 = 5%. If the interest rate exceeds
5%, then there are better investments elsewhere. If the interest rate is less than 5%, this is
a good deal.
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

17
Copyright © 2015 Pearson Education, Inc.
31) What is the internal rate of return on a new $2,000 heater that would reduce your
heating costs by $200 a year forever? Under what conditions would you make the
purchase?
Answer: The internal rate of return is 200/2,000 = 10%. The purchase should be made as
long as the interest rate is less than 10%.
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

32) You grow poplar trees. The lumber yard purchases cut trees from you. The trees grow 1
foot per year. Assuming a constant real price per foot for poplar and a real interest rate of
3%, would you sell a 20-foot tree today?
Answer: Do not sell yet. The tree is growing at a 5% rate. Selling the tree and putting the
proceeds in the bank would only yield 3%. Wait until the tree is 33.33 feet tall.
Section: Choices Over Time
Question Status: Old
AACSB: Analytic thinking

16.3 Exhaustible Resources

1) If an exhaustible resource is scarce, has constant marginal cost over time, and is sold in
a competitive market, then
A) its price increases over time.
B) its price will not be a function of the interest rate.
C) its price moves independently of past prices.
D) its price equals marginal cost.
Answer: A
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

2) If an exhaustible resource is priced at marginal cost that remains constant over time,
then
A) all owners of that resource earn rent.
B) the price will stay constant over time.
C) the percent price increase each year equals the rate of interest.
D) the good is relatively scarce.
Answer: C
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

18
Copyright © 2015 Pearson Education, Inc.
3) An exhaustible resource with a very large known reserve will most likely exhibit
A) a highly variable price in the near future.
B) a decreasing price in the near future.
C) an increasing price in the near future.
D) a constant price in the near future.
Answer: D
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

4) If a non-renewable resource is scarce, has constant marginal cost of production and is

sold in a competitive market,
A) its price will increase over time.
B) its price will exceed marginal cost.
C) its price will increase by the rate of interest.
D) All of the above.
Answer: D
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

5) In reality, prices of non-renewable resources have not increased continually according to

the model developed in Section 16.3 because of
A) abundance of the resource.
B) technological progress changing marginal cost.
C) changing market power of producers.
D) All of the above.
Answer: D
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

6) Suppose an exhaustible resource can be sold only this period or next period. The
resource owner is considering selling 100 tons of the resource this period. The future value
of the resource when 100 tons are sold this period is less than the present value of the 100
tons sold this period multiplied by one plus the interest rate. What should the resource
owner do?
A) She should sell more than 100 tons this period.
B) She should sell only 100 tons this period.
C) She should sell less than 100 tons this period.
D) She should not sell any of the resource in either period.
Answer: A
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

19
Copyright © 2015 Pearson Education, Inc.
7) Technological improvements in coal mining will
A) increase the price of coal.
B) decrease the price of coal.
C) increase the interest rate.
D) decrease the interest rate.
Answer: B
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

8) The growth over time in the spread between price and marginal cost of an exhaustible
resource is equal to
A) zero.
B) one.
C) the interest rate.
D) the present value of the reserves.
Answer: C
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

9) The spread between price and marginal cost of an exhaustible resource must grow by
the rate of interest so that
A) resource owners earn a profit.
B) resource owners are willing to sell some of the resource in the future.
C) the price of the resource remains constant in real terms.
D) the marginal cost of extracting the resource declines.
Answer: B
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

10) Consider a wine maker who has put her wine in bottles. The question is whether to
store the wine for a marginal cost of $1 per year or to sell the wine today at a price of $10.
If the interest rate is 6%, how much must the price of the wine increase in the next year to
justify storing it?
A) $1.66
B) $1.27
C) $0.72
D) $0.45
Answer: A
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

20
Copyright © 2015 Pearson Education, Inc.
11) In the later part of the twentieth century, the price of crude oil began to increase after
decades of relatively steady prices, which of the following could explain this phenomenon?
A) Worldwide reserves have been increasing.
B) Worldwide demand has been increasing.
C) Global warming
D) Extraction technology has been degrading.
Answer: B
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

12) If extraction technology continues to improve over time,

A) the price of crude oil can continue to fall or stay steady.
B) the price of crude oil will increase despite any attempts to stem demand.
C) the price of crude oil will only fall if sufficient government taxation is implemented.
D) the price of crude oil will only fall if sufficient demand declines are arranged.
Answer: A
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

13) Suppose we know that 10 Spanish Galleons sunk in the Atlantic ocean carrying
approximately 50 tons of gold, but the exact location of these shipwrecks is unknown.
Would this gold add to the world reserve?
A) Yes, we know it exists.
B) No, we know it exists but we can't extract the gold.
C) Yes, it's only a matter of time before the shipwrecks are discovered.
D) No, there are no established property rights over the shipwreck so they cannot add to
world reserves..
Answer: B
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

14) Suppose an astronomer discovers gold on the moon. Would this gold add to the world
reserves?
A) Yes, we know it exists and we could recover it.
B) No, we know it exists but we can't extract the gold.
C) No, there are no established property rights over the moon so they cannot add to world
reserves..
D) Yes, but only if the astronomer is the resident of a developed country with well-
established property rights.
Answer: A
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

21
Copyright © 2015 Pearson Education, Inc.
15) Alchemy was the attempt to discover a process by which base metals, such as lead,
could be turned into gold. If an alchemist had been successful,
A) all the lead in the world would have been added to the world's gold supply.
B) all the lead in the world would have replaced the world's gold supply.
C) all the lead in the world would only have been added to the world's gold supply when it
was converted to gold.
D) the alchemist would likely have been killed by the owners of real gold.
Answer: A
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

16) Which of the following is an example of an exhaustible resource?

A) silver
B) soybeans
C) pork belly
D) pound cake
Answer: A
Section: Exhaustible Resources
Question Status: New
AACSB: Analytic thinking

For the following, please answer "True" or "False" and explain why.

17) As in all other competitive markets price equals marginal cost in a market for a scarce,
non-renewable resource that is traded in a competitive market.
Answer: False. Price exceeds marginal cost in those markets because owners of those
resources receive a rent. It is a compensation for the ownership of this scarce resource.
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

18) Why is the price of a scarce exhaustible resource in a competitive market above the
marginal cost of providing a unit of the resource?
Answer: Because the resource is scarce, the owner receives a rent. The addition of the
rent increases the price above the marginal cost of providing the resource.
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

19) Explain how continuing technical progress may cause the price of scarce, exhaustible
resources to fall over time.
Answer: Technical progress can lower the extraction cost of exhaustible resources. This
decrease in extraction costs can offset the increase in price due to the positive interest
rate. This may result in lower resource prices over time.
Section: Exhaustible Resources
Question Status: Old
AACSB: Analytic thinking

20) Suppose coal sells for $50 per ton and can be mined at a constant marginal cost of $20
per ton. Forecasters predict that the price of coal next year will be $55. If your marginal
cost next year will still be $20 and the interest rate is 10%, do you sell coal today?
Answer: You are indifferent if coal prices rise (10% of 50 - 20) by $3. Since coal prices are
expected to rise by $5, you will wait until next year.
Section: Exhaustible Resources
Question Status: Old
22
Copyright © 2015 Pearson Education, Inc.
AACSB: Analytic thinking

16.4 Capital Markets, Interest Rates, and Investments

1) Investment demand is downward sloping because

A) an increase in investment demand causes interest rates to fall.
B) at lower interest rates, firms will undertake more investment.
C) at lower interest rates, firms will undertake less investment.
D) none of the above.
Answer: B
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

2) Investment demand is downward sloping because as the interest rate decreases,

A) each project's internal rate of return decreases.
B) each project's internal rate of return increases.
C) more projects will have an internal rate of return that exceeds the interest rate.
D) more projects will have an internal rate of return that is less than the interest rate.
Answer: C
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

3) Government policies that encourage savings

A) reduce interest rates.
B) increase interest rates.
C) have no effect on interest rates.
D) lower the net present value of all investments.
Answer: A
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

23
Copyright © 2015 Pearson Education, Inc.
4) Which of the following is most likely to cause interest rates to fall?
A) Government borrows to finance a war.
B) All firms project higher future revenue streams for all of their projects.
C) All firms project lower future revenue streams for all of their projects.
D) Government institutes a high tax on savings.
Answer: C
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

5) Which of the following is most likely to cause the savings supply curve in the market for
loanable funds to shift leftward?
A) Government borrows to finance a war.
B) All firms project higher future revenue streams for all of their projects.
C) All firms project lower future revenue streams for all of their projects.
D) Government institutes a high tax on savings.
Answer: D
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

6) Which of the following is most likely to cause the demand curve in the capital market to
shift leftward?
A) Government borrows to finance a war.
B) All firms project higher future revenue streams for all of their projects.
C) All firms project lower future revenue streams for all of their projects.
D) Government institutes a high tax on savings.
Answer: C
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

7) Government borrowing may crowd out borrowing by private interests because

A) funds are not available at any interest rate.
B) the equilibrium interest rate increases.
C) the supply curve shifts to the left.
D) None of the above.
Answer: B
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

24
Copyright © 2015 Pearson Education, Inc.
8) When a government turns a deficit into a surplus we would expect
A) interest rates to rise.
B) interest rates to decrease.
C) the demand curve for loanable funds to shift rightward.
D) that more investment is crowded out.
Answer: B
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

9) A government policy that lets individuals put away money for retirement tax-free will
A) shift the demand curve for loanable funds rightward.
B) crowd out private investment.
C) shift the supply curve of loanable funds to the right.
D) induce people to save less at any interest rate.
Answer: C
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

10) As the baby boomer generation retires and takes money out of their retirement
accounts, what is expected to happen to the interest rate, ceteris paribus?
A) It will increase.
B) It will not change.
C) It will decrease.
D) It will decrease because of demand-side shocks.
Answer: A
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

11) If a recession were to reduce the demand for loans, ceteris paribus,
A) the interest rate will increase.
B) the interest rate will not change.
C) the interest rate will decrease.
D) the number of loans will increase.
Answer: C
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

25
Copyright © 2015 Pearson Education, Inc.
12) During the Iraq War, the U.S. government continued to borrow funds and yet the
interest rate was steady or slightly declined. What could explain this?
A) The U.S. crowded out private saving.
B) The U.S. crowded out private borrowing.
C) The supply of loanable funds increased by a greater proportion than demand increased.
D) The supply of loanable funds increased by a smaller proportion than demand increased.
Answer: C
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

13) What is one reason for the high interest rates for home loans offered to those with low
credit ratings?
A) Predatory lending practices
B) Those with lower credit ratings faced a restricted supply of loans, ceteris paribus.
C) Those with lower credit ratings typically demand greater loans, ceteris paribus.
D) Government regulation
Answer: B
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

14) If the interest rate received in Mexico is greater than that obtained in the United
States,
A) the demand for loans will increase in Mexico.
B) the supply of loans will decrease in the United States.
C) the supply of loans will decrease in Mexico.
D) the demand for loans will decrease in the United States.
Answer: B
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

15) If the interest rate received in Mexico is greater than that obtained in the United
States,
A) the interest rate will decrease in the United States in the future.
B) the interest rate will increase in the United States in the future.
C) the interest rate will increase in Mexico in the future.
D) the interest rate will not change in either country.
Answer: B
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

26
Copyright © 2015 Pearson Education, Inc.
16) In developed industries, the interest rate tends to be lower than in newer industries.
What could explain this?
A) greater demand for loans in the developed industry
B) greater supply for loans in the new industry
C) greater demand for loans in the new industry
D) lower supply for loans in the developed industry
Answer: C
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

17) A capital gains tax acts to

A) reduce the interest rate received by loan demanders.
B) increase the interest rate received by loan demanders.
C) increase the interest rate received by loan suppliers.
D) reduce the interest rate received by loan suppliers.
Answer: D
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

18) How does a decrease in government budget deficits affect the equilibrium interest rate
in the loanable funds model?
A) Interest rate increases.
B) Interest rate decreases.
C) Interest rate stays the same.
D) Interest rate first increases and then decreases back to the original level.
Answer: B
Section: Capital Markets, Interest Rates, and Investments
Question Status: New
AACSB: Analytic thinking

19) Suppose households decide to reduce savings because they want to enjoy more present
time than future time. In this case, the loanable funds model predicts that
A) interest rate goes down, and quantity of borrowed funds increases.
B) interest rate goes down, and quantity of borrowed funds decreases.
C) interest rate goes up, and quantity of borrowed funds decreases.
D) interest rate goes up, and quantity of borrowed funds increases.
Answer: C
Section: Capital Markets, Interest Rates, and Investments
Question Status: New
AACSB: Analytic thinking

27
Copyright © 2015 Pearson Education, Inc.
20) The nominal interest rate is 7% and the real interest rate is 2.75%. What is the inflation
rate?
A) 3.75%
B) 4.55%
C) 4.25%
D) 9.75%
Answer: C
Section: Capital Markets, Interest Rates, and Investments
Question Status: New
AACSB: Analytic thinking

For the following, please answer "True" or "False" and explain why.

21) Government debt increases the interest rate and private investment.
Answer: False. The interest rate does increase; however, this causes the level of private
investment to decrease.
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

22) A government policy that makes investments prior to retirement tax exempt until
retirement increases the amount saved at any given interest rate.
Answer: True. Allowing investors to earn interest on the amount owed in taxes will shift
out the supply curve of funds.
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

23) Why do economists predict that investment increases when the real rate of interest
falls?
Answer: When the interest rate falls, the present value of a future stream of payments
increases. Some projects that might have been considered unprofitable at a high interest
rate become profitable, and therefore are undertaken, at a lower interest rate.
Section: Capital Markets, Interest Rates, and Investments
Question Status: Old
AACSB: Analytic thinking

28
Copyright © 2015 Pearson Education, Inc.