Economics - Capital Market - Quick Guides | Economics

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Study GuideEconomics–Capital Market1. Capital, Loanable Funds, Interest Rate1.1Capital Markets: Who Supplies and Who Demands Capital?Capital markets are places wherecapital goods(like machines, tools, and buildings) are financed.•Firmsusuallydemand capitalbecause they need machines, factories, and equipment toproduce goods.•Householdsusuallysupply capital, but they do thisindirectly.•Instead of directly giving money to firms, householdssave part of their incomeand depositit in banks.•Banksthen lend these savings to firms.•Firms use these borrowed funds to buy capital goods.In short:Households save → Banks lend → Firms invest1.2 Loanable Funds: What Does the Term Mean?Loanable fundsare the funds that areavailable for borrowing.They include:•Household savings•Bank loansBecause firms often use borrowed money to invest in new capital goods, economists usually discusscapital markets in terms of thedemand and supply of loanable funds.

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Study Guide1.3 Interest Rate: The Price of Borrowing and LendingTheinterest rateplays two important roles:•Forborrowers, it is thecost of borrowing money•Forlenders, it is thereturn earned on lending moneyInterest rates are usually expressed as anannual percentage rate.Example (One-Year Loan)•A firm borrows$20,000forone year•Interest rate =5% per year•Interest = $20,000 × 0.05 =$1,000•Total repayment after one year =$21,0001.4 Compound Interest: When Loans Last More Than One YearIf a loan lasts more than one year,compound interestapplies.Compound interest means:Interest is charged on both the original amount borrowedandthe interest that has alreadyaccumulated.Example (Two-Year Loan)•Loan amount = $20,000•Interest rate = 5% per year•After Year 1: Amount owed = $21,000•In Year 2, interest is charged on$21,000, not just $20,000Final repayment after two years:•$21,000 + (21,000 × 0.05) =$22,050

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Study Guide1.5General Formula for Loan RepaymentIn general, if:•X= amount borrowed•r= annual interest rate•t= number of yearsThen the total amount repaid is:Amount repaid = X (1 + r)ᵗFor example:•X = $20,000•r = 0.05•t = 2Amount repaid = $20,000 × (1.05)² =$22,0501.6Determination of the Equilibrium Interest RateTheequilibrium interest rateis determined in theloanable funds market.This market includes:•Lenders(households and banks)•Borrowers(firms and investors)•Thesupply of loanable fundscomes from lenders.•Thedemand for loanable fundscomes from borrowers.

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Study Guide1.7Loanable Funds Market•Thedemand curveslopes downward:oLower interest rates → more borrowing•Thesupply curveslopes upward:oHigher interest rates → more lending•Theequilibrium interest rateis found at theintersectionof demand and supply.•At this point, the quantity of loanable funds demanded equals the quantity supplied.1.8Rate of Return on Capital and Demand for Loanable FundsTherate of return on capitalis theextra income a firm earnsby using new capital.•It is usually measured as apercentage per year.•Firms will borrow fundsonly if:oRate of return on capital ≥ interest rateIf capital becomesmore productive:•The rate of return increases•Firms want to borrow more•Thedemand curve for loanable funds shifts right•The equilibrium interest raterises, assuming other factors remain the same (ceteris paribus)

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