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Chapter 17: Capital and
Financial Markets
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
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
Demand and supply of capital
An increase in
the interest rate
results in a
reduction in the
quantity of
capital sold
Financial capital
Two types of returns from owning
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