- Study Guide (Course-wide Content)
A. Basic Concepts of Interest and Capital
- Recall the major concepts:
- Capital: durable produced items used for further production
- Rentals: net annual dollar returns on capital goods
- Rate of return on investment: net annual receipts on capital divided by dollar value of capital (measured as percent per year)
- Interest rate: yield on financial assets, measured as percent per year
- Real interest rate: yield on funds corrected for inflation, also measured as percent per year
- Present value: value today of an asset's stream of future returns
- Interest rates are the rate of return on financial assets, measured in percent per year. People willingly pay interest because borrowed funds allow them to buy goods and services to satisfy current consumption needs or make profitable investments.
- We observe a wide variety of interest rates. These rates vary because of many factors such as the term or maturity of loans, the risk and liquidity of investments, and the tax treatment of the interest.
- Nominal or money interest rates generally rise during inflationary periods, reflecting the fact that the purchasing power of money declines as prices rise. To calculate the interest yield in terms of real goods and services, we use the real interest rate, which equals the nominal interest rate minus the rate of inflation.
- Assets generate streams of income in future periods. By calculating the present value of the asset, we can convert the stream of future returns into a single value today. This is done by asking what sum today will generate the total value of all future returns when invested at the market interest rate.
- The exact present-value formula is as follows: Each dollar payable t years from now has a present value (V) of $1/(1 + i)t. So for any net-receipt stream (N1, N2, . . . , Nt), where Nt is the dollar value of receipts t years in the future, we have
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- A third factor of production is capital, a produced durable item that is used in further production. In the most general sense, investing in capital represents deferred consumption. By postponing consumption today and instead producing buildings or equipment, society increases consumption in the future. It is an economic fact that roundabout production yields a positive rate of return.
- Interest is a device that serves two functions in the economy: As a motivating device, it provides an incentive for people to save and accumulate wealth. As a rationing device, interest allows society to select only those investment projects with the highest rates of return. However, as more and more capital is accumulated, and as the law of diminishing returns sets in, the rate of return on capital and the interest rate will be beaten down by competition. Falling interest rates are a signal to society to adopt more capital-intensive projects with lower rates of return.
- Saving and investing involve waiting for future consumption rather than consuming today. Such thrift interacts with the net productivity of capital to determine interest rates, the rate of return on capital, and the capital stock. The funds or financial assets needed to purchase capital are provided by households that are willing to sacrifice consumption today in return for larger consumption tomorrow. The demand for capital comes from firms that have a variety of roundabout investment projects. In long-run equilibrium, the interest rate is thus determined by the interaction between the net productivity of capital and the willingness of households to sacrifice consumption today for consumption tomorrow.
- Profits are revenues minus costs. Remember that economic profits differ from those measured by accountants. Economics distinguishes between three categories of profits: (a) An important source is profits as implicit returns. Firms generally own many of their own nonlabor factors of production—capital, natural resources, and patents. In these cases, the implicit return on owned inputs is part of the profits. (b) Another source of profits is uninsured or uninsurable risk, particularly that associated with the business cycle. (c) Finally, innovational profits will be earned by entrepreneurs who introduce new products or innovations.