Solution Manual for Introduction to Finance, 17th

Edition, Ronald W. Melicher

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Solution Manual for Introduction to Finance, 17th Edition, Ronald W. Melicher

Chapter Seven: Savings and Investment Process

Chapter 7
Savings and Investment Process

CHAPTER PREVIEW

An effective financial system provides the funds needed for an economy to grow in terms of gross
domestic product by channeling savings into investment. The savings-investment process in the
U.S. financial system begins by first generating savings. These savings may be directly invested
by savers, or be accumulated by financial intermediaries which, in turn, lend and invest the
savings. After describing the composition of gross domestic product (GDP), we discuss the
expenditures and receipts of the federal government. We next cover the historical role and
creation of savings in the U.S. Then our attention turns to coverage of the major sources of
savings and the factors that affect savings. The last two sections in the chapter cover first capital
market securities and then provide a further look at the 2007-09 financial crisis.
Instructors will find a vast amount of information on aggregate savings, investment, and
government receipts and expenditures in newspapers, periodicals, and the reports of banks and
other financial institutions. The Economic Report of the President, issued early each year, is an
especially good source of statistical tables and charts as well as general information.

LEARNING OBJECTIVES

LO 7.1 Identify and describe the major components of the gross domestic product (GDP).
LO 7.2 Describe the principal sources of federal government revenues and expenditures.
LO 7.3 Explain how savings are created and describe the major sources of savings in the United
States.
LO 7.4 Identify and describe the factors that affect savings.
LO 7.5 Describe major capital market securities that facilitate the savings and investment process.
LO 7.6 Describe the types of mortgage loans available to individuals and how the mortgage
markets facilitate home ownership.
LO 7.7 Discuss the role of individuals in the 2007–08 financial crisis.

CHAPTER OUTLINE

I. (7.1) GROSS DOMESTIC PRODUCT AND CAPITAL FORMATION

A. GDP Components
B. Implications of International Payment Imbalances

II. (7.2) FEDERAL GOVERNMENT RECEIPTS AND EXPENDITURES

A. The Budget
B. Fiscal Policy Makers
C. Debt Financing

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 Chapter Seven: Savings and Investment Process

III. (7.3) ROLE AND MAJOR SOURCES OF SAVINGS

A. Historical Sources
1. Foreign Sources of Savings
2. Domestic Supply of Savings
B. Creation of Savings
C. Personal Savings
D. Corporate Savings

IV. (7.4) FACTORS AFFECTING SAVINGS

A. Levels of Income
B. Economic Expectations
C. Economic Cycles
D. Life Stages of the Individual Saver
E. Life Stages of the Corporation

V. (7.5) CAPITAL MARKET SECURITIES

VI. (7.6) MORTGAGE MARKETS

A. Types of Mortgages and Mortgage-Backed Securities
B. Credit Ratings and Scores
C. Major Participants in the Secondary Mortgage Markets

VIII. (7.7) ROLE OF THE INDIVIDUAL IN THE 2007-2008 FINANCIAL CRISIS AND
TODAY
A. Early Factors
B. A Borrowing-Related Cultural Shift
C. Subsequent Recovery

IX. SUMMARY

LECTURE NOTES

I. (7.1) GROSS DOMESTIC PRODUCT AND CAPITAL FORMATION

The U.S. operates as a democracy that is based on capitalism. As discussed in Chapter 1, a

democracy is a system of government where limited authority and power are granted by
law to its people who participate by voting on government goals and actions. Capitalism
is an economic system with private ownership of assets, production of goods and services
for profit, a price mechanism for allocating resources, and financial markets. The result of
combining democracy and capitalism is termed democratic capitalism which refers to a
country or state organized as a democracy that uses or adopts a capitalistic economic
system. In contrast, a country or state organized as an autocratic political system that uses
elements of a markets-based economic system is termed autocratic capitalism.

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All of a nation’s output of goods and services may be consumed, or a portion may be
saved and invested to produce economic growth. Capital formation involves the creation
of capital goods including residential and commercial buildings, equipment and machinery,
and business inventories.

Gross domestic product (GDP) is a nation’s output of goods and services for a
specified period of time. GDP is comprised of personal consumption expenditures (PCE),
government purchases of goods and services (GP), gross private domestic investment
(GPDI), and net exports of goods and services (NE). In equation form, we have: GDP =
PCE + GP + GPDI + NE.
(Use Table 7.1 and Review Questions 1, 2, and 3 here.)

II. (7.2) FEDERAL GOVERNMENT RECEIPTS AND EXPENDITURES

The magnitude of the expenditures of federal government and the revenues required to
support such expenditures require much examination when considering any aspect of the
nation’s economy. Expenditures touch all of us—businesses as well as individuals, as do
the various taxes. Although we ordinarily think only of income or corporate taxes, large
sums are raised by the federal government from fees of various types: excise taxes, postal
receipts, rental receipts from federal housing projects, and a host of other sources. In
contrast with the early history of the nation, the federal government now enters virtually all
phases of our economic lives.
Figure 7.1 should stimulate class discussion. As shown in Figure 7.1 for fiscal year
2017, the principal sources of federal revenues are: personal income taxes (40%), social
security and other retirement taxes (29%) borrowing to cover deficit (17%), corporate
income taxes (7%), and excise, estate, and other taxes (7%).
As shown in Figure 7.1 for fiscal 2017, the major expense items in the federal budget
are: social security, medicare, and other retirement (41%), national defense, veterans, and
foreign affairs (20%), social programs (including Medicaid) (22%), physical, human and
community development (8%), net interest on debt (6%), and law enforcement and general
government (2%).

Beginning in 1970 and continuing until fiscal 1998, the federal government operated
with an annual budget deficit. Surplus budgets were achieved during the next four years
(fiscal 1998 through fiscal 2001). Beginning in 2002 budget deficits returned with the
deficits exceeding $1 trillion annually for fiscal years 2009-12. Annual deficits have
continued since then and currently are again greater than $1 trillion.

At the end of fiscal 2000, the national debt was $5.7 trillion. It increased to $21.5
trillion by the end of fiscal 2018. By early calendar 2019, the national debt exceeded $22.0
trillion for the first time.

(Use Figure 7.1 and Review Questions 4, 5, and 6 here.)

III. (7.3) ROLE AND MAJOR SOURCES OF SAVINGS

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Foreign capital played an important role in the economic development of the United
States, for example, in the early transportation system. After the Civil War, the populace in
the U.S. began to take over the function of providing savings for the capital formation
process. Today, the World Bank supplies large amounts of capital to developing nations
for purposes of increasing their productive capacity.

Economic unit savings occur when an economic unit’s income exceeds its expenses,
taxes, and real asset investments. A savings surplus unit is an economic unit that
generates savings. A savings deficit unit is an economic unit with income less than its
expenses, taxes, and real asset investments. For example, a savings deficit occurs when
business firms as a group are unable to meet their working capital (primarily inventories)
and plant and equipment expenditure needs out of earnings retained in their businesses.
Individuals as a group have been a savings surplus unit. Corporations also have been
generally a savings surplus unit. However, governments (both federal and state and local)
have recently been savings deficit units.
(Use Review Questions 7 and 8 here.)

Personal saving is the savings of individuals equal to personal income less personal
current taxes less personal outlays. Voluntary savings are savings held or set aside by
choice for future use. Contractual savings are Savings accumulated on a regular
schedule by prior agreement. For example, the accumulation of reserves in insurance and
pension funds would be examples of contractual savings.

The personal savings rate is personal savings divided by disposable personal income.
Historical U.S. personal savings rates are shown in Table 7.2. These rates were at
double-digit levels in 1960, 1970 and 1980 before declining to 7.8% in 1990, 4.2% in
2000, and 5.6% in 2010. Personal savings rates for selected recent years are provided in
Table 7.3 and were: 2006 (3.3%), 2009 (6.1%), 2015 (5.1%), and 2018 (6.7%).

Savings are the financial assets retained by the corporation out of funds generated
through business operations that are neither paid out in dividends nor invested in
operating assets of the business. Funds generated through business operations include not
only corporate earnings but also the conversion of operating assets to financial assets
through depreciation allowances. Corporations have short-term saving for working
capital purposes and long-term saving to meet future expenditures for equipment, major
maintenance, and the like. See Table 7.4 for nonfinancial corporate savings in 2006,
2009, 2015, and 2018.

(Use Tables 7.2, 7.3, and 7.4, and Review Questions 9 through 12 here.)

IV. (7.4) FACTORS AFFECTING SAVINGS

Savings are defined as current income less tax payments and consumption expenditures.
Factors that influence the total amount of savings in any given time period include:
1. Levels of income

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2. Economic expectations
3. Economic cycles
4. Life stages of the individual saver
5. Life stages of the corporation
Changes in business activity influence employment levels which, in turn, are closely
associated with income levels. Cyclical movements in the economy affect both the level of
savings and the types of savings. Dissaving involves spending of accumulated savings
when consumption spending exceeds after-tax income.

The instructor can generally involve the class in a lively discussion of the level of
savings as they relate to the life stage of the individual saver. This discussion can often be
extended to how the life stage of business firms, particularly corporations, impact on their
level of savings.

(Use Review Questions 13 through 18 here.)

V. (7.5) CAPITAL MARKET SECURITIES

The two types of financial markets are money markets and capital markets. Money
markets are markets where debt securities of one year or less are issued or traded.
Capital markets are markets where debt securities with maturities longer than one year
and corporate stocks are issued or traded. Securities that are created or traded in the
capital markets are called capital market securities.

Figure 7.2 lists five major capital market securities. They are:

Mortgage: loan backed by real property in the form of buildings and houses. Typical
maturities are 5 to 30 years.
Treasury note/bond: longer-term debt instrument issued by the U.S. federal government.
Typical maturities are 2 to 30 years.
Municipal bond: longer-term debt instrument issued by a state or local government.
Typical maturities are 2 to 40 years.
Corporate bond: debt instrument issued by a corporation to raise long-term funds.
Typical maturities are 2 to 30 years.
Common stock: security that indicates ownership interest in a corporation. There are no
maturities on common stocks.

(Use Figure 7.2 and Review Questions 19 and 20 here.)

VI. (7.6) MORTGAGE MARKETS

The term mortgage, a loan backed by real property in the form of buildings and houses,
was defined in the capital market securities section. Mortgage markets are markets in
which mortgage loans to purchase houses and buildings are created (or originated) and

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traded. Residential real estate mortgages are either fixed-rate mortgages where the interest
rate is fixed over the life of the loan, or an adjustable-rate mortgage (ARM) where the
interest rate varies over time with a U.S. Treasury bill or other debt security.

Securitization is the process of pooling or packaging mortgage loans into debt

securities. A mortgage-backed security is a debt security created by pooling together a
group of mortgage loans. A credit rating indicates the expected likelihood that a borrower
will pay a debt according to the terms agreed to. A credit rating is typically expressed in
terms of a credit score with a relatively high credit score being associated with a prime
mortgage loan.

The federal government has played an active role in the development of secondary
mortgage markets. Government efforts included:

Federal National Mortgage Association (Fannie Mae)—created in 1938

Government National Mortgage Association (Ginnie Mae)—created in 1968
Federal Home Loan Mortgage Corporation (Freddie Mac)—created in 1970

(Use Review Questions 21 through 25 here.)

VII. (7.7) ROLE OF THE INDIVIDUAL IN THE 2007-08 FINANCIAL CRISIS

The seeds of the 2007-08 financial crisis were sown in the 2001 recession. Stock prices
peaked in 2000 with the bursting of the internet “bubble. Monetary and fiscal policy
attempted to stimulate economic activity by creating an environment of low interest
rates and high liquidity.

Historically, U.S. consumers limited their use of debt. However, by the first decade
of the twenty-first century, U.S. consumers wanted sooner, if not instant gratification
with respect to buying large-ticket items. The use of credit cards increased dramatically
and consumers borrowed heavily to purchase homes and other expensive durable goods.
The U.S. government encouraged the expansion of home ownership to include
individuals with relatively high credit risks. The bursting of the “housing price” bubble
in mid-2006, followed by the decline in economic activity that resulted in a recession,
caused many individuals not to be able to meet their mortgage payments and other debt
obligations.

(Use Review Question 26 here.)

REVIEW QUESTIONS AND ANSWERS

I. (LO 7.1) Describe the terms autocratic capitalism and democratic capitalism and discuss the
model followed by the U.S.
As discussed in Chapter 1, a democracy is a system of government where limited authority
and power are granted by law to its people who participate by voting on government goals
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and actions. Capitalism is an economic system with private ownership of assets, production
of goods and services for profit, a price mechanism for allocating resources, and financial
markets. The result of combining democracy and capitalism is termed democratic
capitalism which refers to a country or state organized as a democracy that uses or adopts a
capitalistic economic system. In contrast, a country or state organized as an autocratic
political system that uses elements of a markets-based economic system is termed autocratic
capitalism.

The U.S. operates as a democracy that is based on capitalism. The result of combining
democracy and capitalism is termed democratic capitalism which refers to a country or state
organized as a democracy that uses or adopts a capitalistic economic system.

2. (LO 7.1) What is capital formation?

All of a nation’s output of goods and services may be consumed, or a portion may be
saved and invested to produce economic growth. Capital formation involves the creation of
capital goods including residential and commercial buildings, equipment and machinery, and
business inventories.

3. (LO 7.1) Describe the major components of gross domestic product.

Gross domestic product (GDP) is comprised of: (a) personal consumption expenditures
(PCE) which are expenditures by individuals for durable goods, nondurable goods, and
services; (b) government purchases (GP) which are expenditures for goods and services by
both the federal and the state and local governments; (c) gross private domestic investment
(GPDI) which measures fixed investment in residential and nonresidential structures,
producers’ durable equipment, and changes in business inventories; and (d) net exports (NE)
of goods and services (i.e., exports minus imports). In equation form, we have: GDP = PCE
+ GP + GPDI + NE. Also see Table 7.1.

4. (LO 7.2) Identify the various sources of revenues in the federal government.

As shown in Figure 7.1 for fiscal year 2017, the principal sources of federal revenues are:
personal income taxes (40%), social security and other retirement taxes (29%) borrowing
to cover deficit (17%), corporate income taxes (7%), and excise, estate, and other taxes
(7%).

5. (LO 7.2) Identify the major expense categories in the federal budget.

As shown in Figure 7.1 for fiscal 2017, the major expense items in the federal budget are:
social security, medicare, and other retirement (41%), national defense, veterans, and foreign
affairs (20%), social programs (including Medicaid) (22%), physical, human and community
development (8%), net interest on debt (6%), and law enforcement and general government
(2%).

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6. (LO 7.2) Describe whether the federal government has been operating with surplus or deficit
budgets in recent years.

Beginning in 1970 and continuing until fiscal 1998, the federal government operated with an
annual budget deficit. Surplus budgets were achieved during the next four years (fiscal
1998 through fiscal 2001). Beginning in 2002 budget deficits returned with the deficits
becoming increasingly larger in most recent years with deficits exceeding $1 trillion
annually for fiscal years 2009-2012. Annual deficits have continued since then and
currently are again over $1 trillion.

At the end of fiscal 2000, the national debt was $5.7 trillion. It increased to $21.5 trillion
by the end of fiscal 2018. By early calendar 2019, the national debt exceeded $22.0 trillion
for the first time.

7. (LO 7.3) Briefly describe the historical role of savings in the United States.

In the earliest days of our economic development, most of the savings came from foreign
sources. After the Civil War, the United States gradually developed to the point at which
American families took over the function of providing savings for investment. In recent
years, savings have been high enough for large-scale investment in foreign countries.

8. (LO 7.3) Compare savings surplus and savings deficit units. Indicate which economic units
are generally one type or the other.

Economic unit savings occur when an economic unit’s income exceeds its expenses, taxes,
and real asset investments. Savings are held in the form of cash and other financial assets. A
savings surplus unit is an economic unit that generates savings. These surplus savings are
made available to savings deficit units A savings deficit unit is an economic unit with
income less than its expenses, taxes, and real asset investments, making it necessary to
acquire funds from a savings surplus unit.

Savings in recent years generally have come from individuals and business corporations.
The federal government has been a savings deficit unit in recent years. State and local
governments also have been operating with deficit budgets in recent years.

9. (LO 7.3) Define personal saving.

Personal saving is the savings of individuals and equals personal income less personal
current taxes less personal outlays.

10. (LO 7.3) Also, differentiate between voluntary and contractual savings.
Voluntary savings are financial assets set aside for future use. Contractual savings are
disciplined by previous commitments and include such things as the accumulation of reserves
in insurance and pension funds.

11. (LO 7.3) Describe the recent levels of savings rates in the United States.

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Refer to Tables 7.2 and 7.3. The savings rate is defined as personal savings divided by
disposable personal income. U.S. savings rates were at double-digit levels in 1960, 1970 and
1980 before declining to 7.8% in 1990 and 4.2% in 2000, and then increasing to 5.6% in
2010. Personal savings rates for selected recent years were: 2006 (3.3%), 2009 (6.1%),
2015 (5.1%), and 20185 (6.7%).

12. (LO 7.3) How and why do corporations save?

Undistributed profits are earnings retained in the business. They are profits remaining after
taxes and, in the case of corporations, after the cash dividends are paid to stockholders.
Savings are the financial assets retained by the corporation out of funds generated through
business operations that are neither paid out in dividends nor invested in operating assets of
the business. Funds generated through business operations include not only corporate
earnings but also the conversion of operating assets to financial assets through depreciation
allowances. Corporations have short-term saving needs for working capital purposes and
long-term saving needs to meet future expenditures for equipment, major maintenance, and
the like. See Table 7.4 for nonfinancial corporate savings in 2006, 2009, 2015, and 2017.

13. (LO 7.4) Describe the principal factors that influence the level of savings by individuals.
The principal factors that influence the levels of savings by individuals are: (a) levels of
income; (b) economic expectations; (c) economic cycles; and (d) the life stage of the
individual saver. A discussion of each of these is provided in the chapter.

14. (LO 7.4) How do economic cycle movements affect the media or types of savings by
businesses?
Cyclical movements in the economy are the primary cause of changes in levels of income,
and they affect not only the amounts but also the types of savings. Economic cycles may be
viewed in terms of the two- to four-year traditional business cycle or in terms of much
longer cycles that correspond with generations of people.

Short-term or money market rates usually decrease during a period of economic downturn,
remain relatively low during the early stages of economic recovery, rise rapidly with rapid
economic growth, and peak when economic activity peaks. Financial intermediation takes
place as long as the interest rates on time and savings deposits exceed other money market
rates. Disintermediation occurs when the reverse interest rate relationship exists. The
elimination of interest rate ceilings on time and savings deposits has resulted in a lessening of
cyclical swings between intermediation and disintermediation.

15. (LO 7.4) What are the life cycle stages of individuals?

The life cycle stages of individuals are: (a) formative/education developing, (b) career
starting/family creating, (c) wealth building, and (d) retirement enjoyment.

16. (LO 7.4) How does each stage relate to the amount and type of individual savings?

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During the first stage (formative/education developing) there typically is no savings but rather a
consumption of their parents’ savings. During the second stage (career starting/family
creating), there is little savings but an earning power potential has been established. Most
savings occur during the third stage (wealth building), while the fourth stage (retirement
enjoyment) often involves dissaving.

17. (LO 7.4) What are the life cycle stages of corporations and other business firms?
The life cycle stages of a successful business firm are: (a) start-up stage, (b) survival stage,
(c) rapid growth stage, and (d) maturity stage.

18. (LO 7.4) Explain how financial savings generated by a business are a function of its life
cycle?
During the and early stages and at least during the early part of the rapid growth stage of a
successful business, the need to replace and add physical or real assets causes the firm to
dissave; that is, the firm usually relies heavily on borrowed capital. However, as the firm
becomes more mature, expansion begins to slow and this, along with a continuing large
flow of cash, results in financial savings.

19. (LO 7.5) What are the two types of financial market securities?

The two types of maturity-related financial markets are money markets and capital
markets. Money markets are markets where debt securities of one year or less are issued
or traded. Capital markets are markets where debt securities with maturities longer than
one year and corporate stocks are issued or traded.

Money market securities are debt instruments or securities with maturities of one year
or less. Capital market securities are debt securities with maturities longer than one year
and corporate stocks.

20. (LO 7.5) Identify and briefly describe the major securities that are originated or traded in
capital securities markets.

Figure 7.2 lists the following five major capital market securities:
Mortgage: loan backed by real property in the form of buildings and houses.
Treasury bond: long-term debt instrument issued by the U.S. federal government.
Municipal bond: long-term debt instrument issued by a state or local government.
Corporate bond: debt instrument issued by a corporation to raise long-term funds.
Common stock: security that indicates ownership interest in a corporation.

21. (LO 7.6) What is a mortgage? What is meant by the term mortgage markets?
A mortgage is a loan backed by real property in the form of houses and buildings.
Mortgage markets are markets in which mortgage loans to purchase houses and buildings
are created (or originated) and traded.

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22. (LO 7.6) Identify and briefly describe the two major types of residential real estate
mortgages.

A fixed-rate mortgage has a fixed interest rate and constant monthly payments over the life
of the loan (typically 15 or 30 years).
An adjustable-rate mortgage (ARM) has an interest rate that varies over time with market-
determined interest rates on a U.S. Treasury bill or other debt security.

23. (LO 7.6) What is meant by the term securitization? What is a mortgage-backed security?

Securitization is the process of pooling and packaging mortgage loans in debt securities.

A mortgage-backed security is a debt security created by pooling together a group of

mortgage loans whose periodic payments belong to the holders of the security. Some of
these securities pass through the interest and principal payments to the owners of the
securities.

24. (LO 7.6) Briefly describe credit ratings and credit scores.
A credit rating indicates the expected likelihood that a borrower will miss interest or
principal payments and possibly default on a debt obligation (loan, mortgage, or bond).

A credit score is a value or number that indicates the creditworthiness or likelihood that a
borrower will make loan payments when due.

25. (LO 7.6) Identify and describe the roles of several major participants in the secondary
mortgage markets.

Mortgage companies originate and sell mortgage loans in secondary mortgage markets.
Banks and other depository institutions also originate mortgage loans and either hold them or
package them as mortgage-backed securities that are sold in the secondary mortgage markets.
The federal government played an active role in the development of secondary mortgage
markets through the initial creation of three major institutions.
The Federal National Mortgage Association (Fannie Mae) was created in 1938 to support the
mortgage markets by purchasing home mortgages from banks.
The Government National Mortgage Association (Ginnie Mae) was created in 1968 to invest
in mortgages made to low-to-moderate income home purchasers.
The Federal Home Loan Mortgage Corporation (Freddie Mac) was created in 1970 to also
support the secondary mortgage markets.

26. (LO 7.7) What role did individuals play in the development of the 2007-09 financial crisis?

Historically, U.S. consumers limited their use of debt. However, by the first decade of the
twenty-first century, U.S. consumers wanted sooner, if not instant gratification with respect
to buying large-ticket items. The use of credit cards increased dramatically and consumers
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borrowed heavily to purchase homes and other expensive durable goods. The U.S.
government encouraged the expansion of home ownership to include individuals with
relatively high credit risks. The bursting of the “housing price” bubble in mid-2006,
followed by the decline in economic activity that resulted in a recession, caused many
individuals not to be able to meet their mortgage payments and other debt obligations.

EXERCISES AND ANSWERS

1. Go to the U.S. Department of Commerce, Bureau of Economic Analysis website at

http://www.bea.gov, click on the National table, and determine the following:

a. The current personal savings rate in the United States.

The instructor will need to access the Department of Commerce web site to supplement
the current personal savings rates indicated in the chapter.

b. The amount of current corporate savings as reflected in the amount of undistributed

profits.

The instructor will need to access the web site for the Department of Commerce to
supplement the corporate savings data presented in the chapter.

2. Assume you are an elected member of Congress. A lobbying group has agreed to provide
financial support for your reelection campaign next year. In return for the group’s support,
you have been asked to champion their self-interests in the form of a spending bill that is
being considered by Congress. What would you do?

Ethical behavior is how an individual or organization treats other legally, fairly, and
honestly. As an elected member of Congress you have a responsibility to all of your
constituencies. Most individuals who seek election to Congress will need financial support
of a variety of backers. However, it would be unethical to “blindly” support the self-
interests of one group at the expense of other constituencies. It would be prudent to
independently assess the merits of the spending bill being considered by Congress and its
likely impact on all of your constituents so that you can make a well-informed, independent
judgment.

3. Match the following financial instruments and securities with their issuers.

Instruments/Securities Issuers
a. corporate stocks [#2] 1. commercial banks
b. Treasury bonds [#3] 2. corporations
c. municipal bonds [#4] 3. U.S. government
d. negotiable certificates of deposit [#1] 4. state/local governments

4. Match the following financial instruments and securities with their typical maturities.

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Instruments/Securities Maturities
a. corporate stocks [#2] 1. 2 to 40 years
b. Treasury notes/bonds [#3] 2. no maturity
c. mortgages [#4] 3. 2 to 30 years
d. municipal bonds [#1] 4. 5 to 30 years

PROBLEMS AND ANSWERS

1. A very small country’s gross domestic product (GDP) is $12 million.

a. If government expenditures amounted to $7.5 million and gross private domestic

investment is $5.5 million, what would be the amount of net exports of goods and
services?

GDP = PCE + GE + GPDI + NE

Where GDP = gross domestic product; PCE = personal consumption expenditures, GE =
government expenditures, GPDI = gross private domestic investment, and NE = net
exports of goods and services.

The NE cannot be determined unless we know PCE.

NE = $12 million - ?$PCE - $7.5 million - $5.5 million
For example, if personal consumption expenditures = $0.0 million, then:
NE = $12 million - $0.0 - $7.5 million - $5.5 million = -$1 million
A positive amount of PCE would result in the NE being an even larger deficit number.

2. How would your answer change in Problem 1 if the gross domestic product had been $14
million?

See comments for Problem 1.

NE = $14 million - ?$PCE - $7.5 million - $5.5 million
PCE could be $1 million before NE would turn negative.

3. Personal income amounted to $17 million last year. Personal current taxes amounted to $4
million and personal outlays for consumption expenditures, non-mortgage interest, and so
forth were $12 million.

a. What was the amount of disposable personal income last year?

Disposable personal income (DPI) = personal income – personal current taxes

DPI = $17 million - $4 million = $13 million

b. What was the amount of personal saving last year?

Personal savings (PS) = disposable personal income – personal outlays

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PS = $13 million - $12 million = $1 million

c. Calculate personal saving as a percentage of disposable personal income.

Savings rate = $1 million/$13 million = 7.7%

4. Assume personal income was $28 million last year. Personal outlays were $20 million and
personal current taxes were $5 million.

a. What was the amount of disposable personal income last year?

Disposable personal income (DPI) = personal income – personal current taxes

DPI = $28 million - $5 million = $23 million

b. What was the amount of personal saving last year?

Personal savings (PS) = disposable personal income – personal outlays

PS = $23 million - $20 million = $3 million

c. Calculate personal saving as a percentage of disposable personal income.

Savings rate = $3 million/$23 million = 13.0%

5. The components that comprise a nation’s gross domestic product were identified and
discussed in the chapter. Assume the following accounts and amounts were reported by a
nation last year. Government purchases of goods and services were $5.5 billion; personal
consumption expenditures were $40.5 billion; gross private domestic investment amounted to
$20 billion; capital consumption allowances were $4 billion; personal savings were estimated
at $2 billion; imports of goods and services amounted to $6.5 billion; and the exports of goods
and services were $5 billion.
a. Determine the nation’s gross domestic product.
See combined GDP solutions for (a) and (b) under (b).
b. How would your answer change if the dollar amounts of imports and exports are
reversed?
Part A Part B
Personal consumption expenditures (PCE) $40.5 billion $40.5 billion
Gross private domestic investment (GPDI) 20.0 billion 20.0 billion
Government purchases of goods & services (GP) 5.5 billion 5.5 billion
Net exports (NE) [calculated as exports – imports] –1.5 billion 1.5 billion
Gross domestic product (GDP) $64.5 billion $67.5 billion

6. Assume some of the data provided in Problem 5 changes next year. Specifically, government
purchases of goods and services increase by 10 percent; gross private domestic investment
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 Chapter Seven: Savings and Investment Process

declines by 10 percent; and the imports of goods and services drop to $6 billion. Assume the
other information as given remains the same next year.
a. Determine the nation’s gross domestic product for next year.

Personal consumption expenditures (PCE) $40.50 billion

Gross private domestic investment (GPDI) 18.00 billion
Government purchases of goods & services (GP) 6.05 billion
Net exports (NE) [exports – imports] -1.00 billion
Gross domestic product (GDP) $63.55 billion

b. How would your answer change in (a) if personal consumption expenditures are only
$35 billion next year and capital consumption allowances actually increase by
10 percent?

Personal consumption expenditures (PCE) $35.00 billion

Gross private domestic investment (GPDI) 18.00 billion
Government purchases of goods & services (GP) 6.05 billion
Net exports (NE) [exports – imports] -1.00 billion
Gross domestic product (GDP) $58.05 billion

7. A nation’s gross domestic product is $600 million. Its personal consumption expenditures
are $350 million and government purchases of goods and services are $100 million. Net
exports of goods and services amount to $50 million.
a. Determine the nation’s gross private domestic investment.
See combined GPDI solutions for (a) and (b) under (b).
b. If imports exceed exports by $25 million, how would your answer to (a) change?
GDP = PCE + GPDI + GP + NE
GPDI = GPD – PCE – GP – NE
Part A Part B
GDP $600 million $600 million
Less PCE –350 million –350 million
Less GP –100 million –100 million
Less NE –50 million +25 million
GPDI $100 million $175 million

8. A nation’s gross domestic product (GDP) is stated in U.S. dollars at $40 million. The dollar
value of one unit of the nation’s currency (FC) is $0.25.
a. Determine the value of GDP in FC’s.
$40 million × $.25 = 10 million FCs
b. How would your answer change if the dollar value of one FC increases to $0.30?

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 Chapter Seven: Savings and Investment Process

$40 million × $.30 = 12 million FCs

9. A country in Southeast Asia states its gross domestic product (GDP) in terms of yen. Last
year its GDP was 50 billion yen when one U.S. dollar could be exchanged into 120 yen.
a. Determine the country’s GDP in terms of U.S. dollars for last year.
(50 billion yen)/120 yen = $416.7 million
b. Assume the GDP increases to 55 billion yen for this year. However, the dollar value of
one yen is now $0.01. Determine the country’s GDP in terms of U.S. dollars for this
year.
(55 billion yen) × $.01 = $550 million
c. Show how your answer in (b) would change if one U.S. dollar could be exchanged for
110 yen.
(55 billion yen)/110 yen = $500 million

10. Challenge Problem (This exercise requires knowledge of probabilities and expected
values.) Following are data relating to a nation’s operations last year.

Capital consumption allowances $150 million

Undistributed corporate profits 40 million
Personal consumption expenditures 450 million
Personal savings 50 million
Corporate inventory valuation adjustment -5 million
Federal government deficit -30 million
Government purchases of goods and services 10 million
State and local governments surplus 1 million
Net exports of goods and services -2 million
Gross private domestic investment 200 million

a. Determine the nation’s gross domestic product (GDP).

Personal consumption expenditures (PCE) $450 million

Gross private domestic investment (GPDI) 200 million
Government purchases of goods & services (GP) 10 million
Net exports (NE) [exports – imports] -2 million
Gross domestic product (GDP) $658 million

b. How would your answer change in (a) if exports of goods and services were $5 million
and imports were 80 percent of exports?

Personal consumption expenditures (PCE) $450 million

Gross private domestic investment (GPDI) 200 million
Government purchases of goods & services (GP) 10 million
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 Chapter Seven: Savings and Investment Process

Net exports (NE) [exports – imports] -1 million

Gross domestic product (GDP) $659 million

c. Show how the GDP in (a) would change under the following three scenarios:
Scenario 1 (probability of .20) that the GDP components would be 120 percent of their
values in (a).
Scenario 2 (probability of .50) that the GDP component values used in (a) would occur.
Scenario 3 (probability of .30) that the GDP components would be 75 percent of their
values in (a).

PCE: (1) $450 million x 1.20 = $540 million; (2) $450 million x 1.00 = $450 million;
and (3) $450 million x .75 = $337.50 million
GPDI: (1) $200 million x 1.20 = $240 million; (2) $200 million x 1.00 = $200
million; and (3) $200 .75 = $150 million
GP: (1) $10 million x 1.20 = $12 million; (2) $10 million x 1.00 = $10 million; and (3)
$10 million x .75 = $7.5 million
NE: (1) $-2 million x 1.20 = $-2.4 million; (2) $-2 million x 1.00 = $-2 million; and (3)
$-2 million x .75 = $-1.5 million

PCE Expected value (in $ millions): $540(.20) + $450(.50) + $337.50(.30) = $108 +

$225 + 101.25 = $434.25 million
GPDI Expected value (in $ millions): $240(.20) + $200(.50) + $150(.30) = $48 +
$100 + 45 = $193
GP Expected value (in $ millions): $12(.20) + $10(.50) + $7.5(.30) = $2.4 + $5 +
$2.25 = $9.65
NE Expected value (in $ millions): $-2.4(.20) + $-2(.50) + $-1.5(.30) = $-.48 + $-1 + $-
.45 = $-1.93

GDP Expected value (in $ millions): $434.25 + $193 +$9.65 + ($-1.93) = $634.97
Check: $658(1.20)(.20) + $658(1.00)(.50) + $658(.75)(.30) = $157.92 + $329.00 +
$148.05 = $634.97

d. Determine the nation’s gross savings last year.

Personal savings $50 million

Undistributed corporate profits 40 million
Corporate inventory valuation adjustment -5 million
Capital consumption allowances 150 million
Federal government deficit -30 million
State and local government surplus 1 million
Gross savings $206 million

e. Show how your answer in (d) would change if each account simultaneously increases by
10 percent.

Gross savings: $206 million x 1.10 = $226.6 million

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Solution Manual for Introduction to Finance, 17th Edition, Ronald W. Melicher

Chapter Seven: Savings and Investment Process

f. Show how your answer in (d) would change if each account simultaneously decreases by
10 percent.

Gross savings: $206 million x .90 = $185.40

g. Show how your answer in (d) would have changed if Capital consumption allowances
had been 10 percent less and personal consumption expenditures had been $400 million.

Capital consumption allowances: $150 million x .90 = $135 million

Personal savings $50 million

Undistributed corporate profits 40 million
Corporate inventory valuation adjustment -5 million
Capital consumption allowances 135 million
Federal government deficit -30 million
State and local government surplus 1 million
Gross savings $191 million

SUGGESTED QUIZ

1. Define or discuss briefly:

a. Capital formation
b. Contractual savings
c. Savings surplus units
d. Capital market securities

2. Identify and describe briefly the major components of gross domestic product.

3. Comment on the general relationship between federal government receipts and expenditures
in recent years.

4. Identify and discuss briefly the major factors that affect savings.

5. List the major capital market securities described in the chapter.

6. Identify the two major types of real estate mortgages.

7. Briefly define the terms credit rating and credit score.

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