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: StudentReturn
(Percent)
Harry5
Ron8
Hermione20
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.

StudentMoney a Year Later
(Dollars)
Harry
Ron
Hermione
Now suppose their school opens up a market for loanable funds in which students can borrow and lend among themselves at an interest rate Three students have each saved $1,000. Each has an .

A student would choose to be a borrower in this market if his or her expected rate of return is ___(Less or Greater) than .

Suppose the interest rate is 7 percent.

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

Now suppose the interest rate is 10 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,(Harry, Hermione, Ron, Ron and Harry, Hermione and Ron) would want to borrow, and (Harry, Hermione, Ron, Ron and Harry, Hermione and Ron) would want to lend.

Suppose the interest rate is at the equilibrium rate.

Complete the following table with how much each student will have a year later after the investment projects pay their return and loans have been repaid.

StudentMoney a Year Later
(Dollars)
Harry
Ron
Hermione
True or False: Only borrowers are made better off, and lenders are made worse off.

True

False

The amount of money the students would have after a year is:

Harry: $1050

Ron: $1080

Hermione: $1200

A student would choose to be a borrower in this market if his or her expected rate of return is greater than the rate of return on investments.

If interest rate is 7%, the quantity of loanable funds supplied would be $100, and quantity demanded would be $200.

If interest rate is 10%, the quantity of loanable funds supplied would be $200, and quantity demanded would be $100.

At an interest rate of 8%, the loanable funds market among these three students would be in equilibrium.

At this interest rate, Hermione would want to borrow and Harry would want to lend.

If interest rate is equilibrium, the amount of money the students would have a year later is:

Harry: $1080

Ron : $1080

Hermione: $1320

Both borrowers and lenders are made better off.

The formula for determining the return on investment is: Amount invested x (1 + rate of return)^n

Harry: 1000 x (1.05) = $1050

Ron: 1000 x (1.08) = $1080

Hermione: 2000 x (1.2) = $2400

Students would choose to lend if the expected return on lending is greater than the rate of return on investment.

At equilibrium, the quantity of loans demanded is equal to the quantity of loans supplied.

When interest rate is 8%, Harry whose return on investment is less than 8%would be willing to lend and hemione would be willing to lend.

Rate of return after a year:

Harry = $1000 x 1.08 = $1080

Ron: 1000 x (1.08) = $1080

Hermione:[ 2000 x (1.2)] $2400 - $1080 = $1320

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Student Money a Year Later:

Harry = Money saved + student return * money saved = $1000 + (5% * 1000) = $1050

Ron = Money saved + student return * money saved = $1000 + (8% * 1000) = $1080

Hermione = Money saved + student return * money saved = $1000 + (20% * 1000) = $1200

Explanation:

a) Student Money a Year Later:

Harry = Money saved + student return * money saved = $1000 + (5% * 1000) = $1050

Ron = Money saved + student return * money saved = $1000 + (8% * 1000) = $1080

Hermione = Money saved + student return * money saved = $1000 + (20% * 1000) = $1200

b) A  student would choose to be a borrower in this market if his or her expected rate of return is greater than the interest rate and lends if his or her expected rate of return is less than the interest rate

c) If interest = 7%, Harry would want to lend while Ron and Hermione would want to borrow. The quantity of funds demanded would be $2,000, while the quantity supplied would be $1,000. If interest = 10%, only Hermione would want to borrow. The quantity of funds demanded would be $1,000, while the quantity supplied would be $2,000.

d) At an interest rate of 8%, the loanable funds market among these three students would be in equilibrium. At this interest rate Hermione would want to borrow, and Harry would want to lend.

e) At equilibrium:

Harry =  $1000 + (8% * 1000) = $1080

Ron = $1000 + (8% * 1000) = $1080

Hermione = $2,000(1 + 0.20) – $1,000(1 + 0.08) = $2,400 – $1,080 = $1,320

Both borrowers and lenders are better off. No one is worse off

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