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Chapter 10: Q6. (page 215)

Suppose a handbill publisher can buy a new duplicating machine for \(500, and the duplicator has a 1-year life. The machine is expected to contribute \)550 to the year's net revenue. What is the expected rate of return? If the real interest rate at which funds can be borrowed to purchase the machine is 8 percent, will the publisher choose to invest in the machine? Will it invest in the machine if the real interest rate is 9 percent? If it is 11 percent?

Short Answer

Expert verified

The expected rate of return of the duplicating machine is 10%.

The publisher will choose to invest if the borrowing interest rate is 8%.

The publisher will choose to invest at a 9% interest rate.

The publisher will choose not to invest at an 11% interest rate.

Step by step solution

01

Computing the expected rate of return

The cost of duplicating a machine (TC) with 1-year life is 500, and the expected revenue (ER) is 550, which gives the expected rate of return (Err) as:

Err=ER-TCTC=550-500500脳100Err=10%

Thus, the expected rate of return for the investment is 10%.

02

Decision to invest if the interest rate is 8%

The handbill publisher will undertake the investment as long as it is profitable to borrow, that is when the real interest rate is less than the expected rate of return.

An 8% interest rate is lower than the Err, which is 10%; hence, the publisher will undertake this investment.

03

Decision to invest if the interest rate is 9%

A 9% interest rate is lower than the Err, which is 10%; hence, the publisher will undertake this investment.

04

Decision to invest if the interest rate is 11%

An 11% interest rate is higher than the Err, which is 10%; hence, the publisher will not undertake this investment.

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Most popular questions from this chapter

Why will a reduction in the real interest rate increase investment spending, other things equal?

Suppose that disposable income, consumption, and saving in some country are \(200 billion, \)150 billion, and \(50 billion, respectively. Next, assume that disposable income increases by \)20 billion, consumption rises by \(18 billion, and saving goes up by \)2 billion. What is the economy鈥檚 MPC? Its MPS? What was the APC before the increase in disposable income? After the increase?

Linear equations for the consumption and saving schedules take the general form C = a + bY and S = 鈭� a + (1 鈭� b)Y, where C, S, and Y are consumption, saving, and national income, respectively. The constant a represents the vertical intercept, and b represents the slope of the consumption schedule.

a. Use the following data to substitute numerical values for a and b in the consumption and saving equations.

National Income (Y)Consumption (C)
\(080
100140
200200
300260
400320

b. What is the economic meaning of b? Of (1 鈭� b)?

c. Suppose that the amount of saving that occurs at each level of national income falls by \)20 but that the values of b and (1 鈭� b) remain unchanged. Restate the saving and consumption equations inserting the new numerical values, and cite a factor that might have caused the change.

In what direction will each of the following occurrences shift the investment demand curve, other things equal?

  1. An increase in unused production capacity occurs.

  2. Business taxes decline.

  3. The cost of acquiring equipment falls.

  4. Widespread pessimism arises about future business conditions and sales revenues.

  5. A major new technological breakthrough creates prospects for a wide range of profitable new products.

Use your completed table for problem 1 to solve this problem. Suppose the wealth effect is such that \(10 changes in wealth produce \)1 changes in consumption at each income level. If real estate prices tumble such that wealth declines by \(80, what will be the new level of consumption and saving at the \)340 billion level of disposable income? The new level of saving?

Level of Output and Income (GDP = DI)
Consumption
Saving
APC
APS
MPC
MPS
\(240
\)244
-$4
1.016
-0.016
0.8
0.2
2602600100.8
0.2
28027640.985
0.014
0.8
0.2
30029280.9730.0260.8
0.2
320308120.962
0.037
0.8
0.2
340324160.9520.0470.8
0.2
360340200.944
0.055
0.8
0.2
380356240.9360.0630.8
0.2
400372280.930.070.80.2
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