Chapter 28 — Exercises

Section A — Loanable funds

A1. Draw the loanable funds market. Label supply (saving), demand (investment), and the equilibrium real interest rate. A2. The government increases its deficit by $500B. Show the effect on the loanable funds diagram. What happens to the interest rate and private investment? A3. Why is crowding out smaller during a recession? A4. If expected inflation rises by 2% but the real interest rate stays the same, what happens to the nominal rate?

Section B — Financial intermediation

B1. Distinguish a bond from a stock. Which is riskier? Which has higher expected return? B2. Why does diversification reduce risk? Give a numerical example with two stocks whose returns are uncorrelated. B3. An investor holds all her savings in one tech stock. Apply the diversification framework: what risk is she taking?

Section C — EMH

C1. Your friend claims to have a stock-picking strategy that beats the market consistently. Apply EMH. How likely is this? C2. EMH says active managers can't beat index funds. Look up the SPIVA scorecard (S&P). What percentage of active funds underperform the S&P 500 over 15 years? C3. If EMH is true, why do asset bubbles (2000 tech, 2006 housing) occur?

Section D — Personal finance

D1. You save $200/month in an index fund earning 7%/year starting at age 22. How much will you have at 65? (Use compound interest.) D2. The same $200/month in a high-fee active fund earning 5%/year (after fees). How much less do you have at 65? D3. "I'll start saving for retirement when I'm 35." Apply the Rule of 70 and compounding to show why this is costly.

Section E — Data lookup

E1. Look up the 10-year Treasury yield (FRED: DGS10) and the federal funds rate (FEDFUNDS). Compare over 20 years. E2. Look up the S&P 500 (SP500) since 2000. Identify the 2000 crash, 2008 crash, COVID crash, and subsequent recoveries.

Section F — Reflection

  • Has this chapter changed how you think about saving and investing?
  • Would you rather invest in an actively managed fund or an index fund? Why?

Selected answers in appendices/answers-to-selected.md.