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Chapter 17: Capital and Financial Markets

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)

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Chapter 17: Capital and Financial Markets

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  1. Chapter 17: Capital and Financial Markets

  2. 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)

  3. 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

  4. 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.

  5. 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

  6. 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.

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

  8. 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

  9. 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)

  10. 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

  11. Risk and rate of return • Riskier assets provide a higher yield

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

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