Capital, Loanable Funds, and Interest Rate

The demand and supply for different types of capital take place in capital markets. In these capital markets, firms are typically demanders of capital, while households are typically suppliers of capital. Households supply capital goods indirectly, by choosing to save a portion of their incomes and lending these savings to banks. Banks, in turn, lend household savings to firms that use these funds to purchase capital goods. The term loanable funds is used to describe funds that are available for borrowing. Loanable funds consist of household savings and/ or bank loans. Because investment in new capital goods is frequently made with loanable funds, the demand and supply of capital is often discussed in terms of the demand and supply of loanable funds.

The interest rate is the cost of demanding or borrowing loanable funds. Alternatively, the interest rate is the rate of return from supplying or lending loanable funds. The interest rate is typically measured as an annual percentage rate. For example, a firm that borrows $ 20, 000 in funds for one year, at an annual rate of 5%, will have to repay the lender $ 21, 000 at the end of the year; this amount includes the $ 20, 000 borrowed plus $ 1, 000 in interest ($ 20, 000 x 0.5).

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If the firm borrows $ 20, 000 for two years at an annual interest rate of 5%, it will have to repay the lender $ 22, 050 at the end of two years. After one year, the firm will owe the lender $21, 000 as explained above; however, because the loan is for two years, the firm does not have to repay the lender until the end of the second year. During the second year, the firm is charged compound interest, which means it is charged interest on both the principal of $ 20, 000 and the accumulated unpaid interest of $ 1, 000.

The equilibrium interest rate is determined in the loanable funds market. All lenders and borrowers of loanable funds are participants in the loanable funds market. The total amount of funds supplied by lenders makes up the supply of loanable funds, while the total amount of funds demanded by borrowers makes up the demand for loanable funds.

Present Value and Investment Decisions. Firms purchase capital goods to increase their future output and income. Income earned in the future is often evaluated in terms of its present value. The present value of future income is the value of having this future income today.

The firm's investment decision is to determine whether to purchase new capital. In determining whether to purchase new capital — for example, new equipment — the firm will take into account the price of the new equipment, the revenue that the new equipment will generate for the firm over time, and the scrap value of the new equipment. The firm will also take into account the interest rate, which represents the firm's opportunity cost of investing in the new equipment. It will use the interest rate to calculate the present value of the future net income that it expects to earn from its purchase of the new capital equipment. If the present value is positive, the firm will choose to purchase the new equipment. If the present value is negative, it is better off forgoing the investment in new equipment.