Chapter 17: Capital and Financial Markets

Capital Capital = buildings and equipment used to produce output Do not confuse capital with “financial capital” Gains from “roundabout production” (producing goods that are used to produce other goods) Capital accumulation requires savings (forgone consumption)

Demand for capital Tied to the MRP of capital over the course of its productive life. Since capital lasts for a long period, firms must take into account the marginal revenue generated by capital and its marginal cost over its entire productive life. Additional capital is used if the present value of the additional benefits is higher than the present value of the additional cost. Present value = current value of future benefits

Present value $1000 received today is worth more than $1000 received in 5 years. Present value of a future balance = amount that must be given up today to receive that amount at the specified future date.

Capital demand curve At a given interest rate, the capital demand curve relates the present value of the MRP of capital to the amount of capital used Holding other resources constant, MRP of capital declines as capital use rises

Capital demand and the interest rate As the interest rate rises, the present value of the MRP stream declines, leading to a reduction in the demand for capital.

Demand and supply of capital An increase in the interest rate results in a reduction in the equilibrium quantity of capital sold

Financial capital Two types of returns from owning stock: Dividends Capital gains Annual return on stock = return from dividends + % change in the value of the stock

Coupon bonds Coupon bonds are corporate bonds that provide a fixed coupon payment each year The market price of a coupon bond may be above or below its face value As interest rates rise, the price of coupon bonds falls The one-year return from a coupon bond = coupon rate + capital gains (or losses)

Discount bonds Bonds that are sold at a price below the face value Yield on these bonds is due to capital gains over the holding period

Risk and rate of return Riskier assets provide a higher yield

Stock prices Determined by the interaction of the demand for and the supply of stock Stock prices rise in response to higher expected profits