Chapter 15

Interest
Rates and the
Capital Market

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In this chapter you will learn to

1. Compute the present value of an asset that delivers a

stream of future benefits.
2. Explain why the demand for investment is negatively
related to the interest rate.
3. Explain why the supply of saving is positively related to the
interest rate.
4. Describe how the equilibrium interest rate is determined
and how it is affected by various economic events.

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 A Brief Overview of the Capital
Market

Investment is the purchase of new capital equipment. It can

be financed by:

• using retained earnings

• borrowing from banks
• issuing bonds or stock

Firms’ demand for financial capital is derived from their

demand for physical capital.

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Figure 15.1 The Interaction of Firms
and Households in the Capital Market

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 Present Value

The Present Value of a Single Future Payment

Consider purchasing a new capital good:
- it produces an MRP of $100 in one year
- it produces nothing thereafter
- how much are you prepared to pay?

If the interest rate is 5% per annum, then the PV is:

PV x (1.05) = $100
PV = $95.24
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Table 15.1 The Present Value of a
Single Sum One Year in the Future

In general, if the interest rate is i percent per year, then the

PV of the MRP received one year hence is:

PV = MRP/(1 + i)

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More Than One Period in the Future

What if the MRP occurs t periods in the future?

The PV of MRP dollars received t years in the future when the

interest rate is i per year is:

PV = MRP/(1 + i)t

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Table 15.2 The Present Value of a Single
Sum Several Years in the Future

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The Present Value of a Stream of
Future Payments

The same basic approach is followed:

- identify when each MRP occurs

- “discount” each MRP back to the present, using

the relevant interest rate

- sum up the terms from each future period

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Table 15.3 The Present Value of a
Stream of Future Payments

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Conclusions

1. Capital is valuable because it generates a stream of future

benefits as measured by MRP.

2. The larger is each MRP, or the longer the stream persists,

the greater is the PV of the capital.

3. The PV is negatively related to the interest rate.

4. The further ahead in time the MRP occurs, the lower is the
PV.

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 The Demand for Capital

The Firm’s Demand for Capital

A profit-maximizing firm buys an additional unit of capital if its

PV exceeds the purchase price.

The firm’s optimal capital stock is such that the PV of the

flow of MRPs that is generated by the last unit of capital is
equal to its purchase price.

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Figure 15.2 The Firm’s
Optimal Capital Stock

The firm’s optimal capital stock is inversely related to the

interest rate.
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Figure 15.3 The Interest Rate and the
Firm’s Investment Demand

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Figure 15.4 The Economy’s
Supply of Saving

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 The Supply of Capital

Saving and Current Income

Household saving is typically positively related to current
income.

An increase in current income increases desired saving (and

thus increases the supply of financial capital).

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Saving and Expected Future Income

An increase in expected future income:

- increases current consumption
 reduces current saving

Saving and the Interest Rate

An increase in the interest rate causes households to:

- reduce their current consumption
 increases their current saving

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The Economy’s Supply of Saving

The economy’s supply of saving shows a positive relationship

between the interest rate and the quantity of saving supplied.
Interest Rate

S What causes S to shift?

1. A rise in current income
 S shifts to right
2. A rise in future income
 S shifts to left

Flow of Saving
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Investment, Saving, and the
Interest Rate
Individuals firms and households take the interest rate as
exogenous, but for the overall economy, the interest rate is
endogenous.

What is the difference between nominal and real interest

rates?

EXTENSIONS IN THEORY 15.1

Inflation and Interest Rates

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Figure 15.5 The Market for
Financial Capital

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Figure 15.6 Changes in Demand and
Supply in the Market for Financial Capital

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Increases in the Supply of Financial
Capital

Three possible causes of an increase in the supply of saving:

1. income growth

2. population growth

3. government policies
– e.g., IRA accounts

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Increases in the Supply of Financial
Capital
Three possible causes of increased investment demand:

1. income and population growth

2. technological improvements that increase MRP

3. government policies
– e.g., investment tax credits

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Figure 15.7 The Capital Stock and
Real Interest Rate, 1965–2005

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Globalized Capital Markets

APPLYING ECONOMIC CONCEPTS 15.1

Investment and Saving in Globalized

Capital Markets

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