Capital Markets and the Interest Rate

Capital — the second key factor of production. The capital market determines how savings are transformed into investments and at what price.

Physical vs financial capital

Physical capital: machines, equipment, buildings — means of production.

Financial capital: money used to purchase physical capital.

The financial capital market coordinates savings and investment.

Interest rate

Interest rate ($r$): the price of using capital.

The price of time — compensation for deferred consumption.

Real vs nominal:

Nominal ($i$): observed rate

Real ($r$): adjusted for inflation

$ r \approx i - \pi \ (\text{inflation}) $

Demand for capital

Firms: invest if the return > cost of capital.

MRP of capital $\geq r$

Demand curve: downward sloping. At low rates — more projects are profitable.

Supply of savings

Households: choose between consumption today and tomorrow.

Higher rate:

Substitution effect: saving is more profitable → more savings

Income effect: future consumption is cheaper → less needs to be saved

Usually: supply of savings rises with the rate.

Equilibrium in the capital market

Equilibrium rate: where savings = investment ($S = I$).

Role of financial intermediaries: banks, markets — channel savings into investments, transform maturities and risks.

Present Value and investment decisions

Present Value (PV): today's value of a future stream.

$ PV = \frac{FV}{(1 + r)^n} $

Net Present Value (NPV): PV of revenues minus costs.

Rule: invest if $NPV > 0$.

For the investor

Cost of capital: baseline parameter for evaluating companies and projects.

Impact of rates:

Low rates: more investments, higher valuations

High rates: fewer investments, lower valuations

Duration: sensitivity of asset values to changes in rates.