0:12
In the ugly duckling example from our last module I mentioned
the word depreciation but I didn't really define it. Here's the deal.
Both investment and depreciation are what we call flow concepts.
Meaning that they are measured per unit of time.
This idea of a flow concept is in sharp contrast to capital which is
a stock concept meaning that capital is measured at a given point in time.
So now hear this, depreciation is an estimate of the loss in the dollar value of
a capital good due to obsolescence or wear and tear during a period of time.
As a practical matter the importance of depreciation is this,
corporations and businesses are allowed to treat depreciation as an expense
on their taxes just like other expenses like labor costs and raw materials.
From a financial accounting standpoint,
there is also this to consider when thinking about depreciation.
In particular, when depreciation over a period of time exceeds
investment over the same period of time the capital stock will decrease.
In contrast, if investment exceeds depreciation,
the capital stock will increase.
For example, suppose the firm ends its fiscal year with a capital stock of $1,000,000 and
then over the course of the current year the firm then
invests $100,000 in new plant equipment.
At the same time it incurs depreciation of $200,000.
What is its capital stock at the end of the current year?
Let's pause the presentation now to figure that out.
2:01
That's right, the answer is $900,000.
Now that we understand both the interest rate and the rate of return,
let's next come to understand how the interaction of
these two critical variables determine investment decisions in a market economy.
In a nutshell we're about to see that firms will demand loanable funds to invest in
new projects so long as the rate of return on capital is
greater than or equal to the interest rate paid on funds borrowed.
We demonstrate this for you now by first introducing the theory of loanable funds.
To begin, let's look at this figure.
It illustrates the market for loanable funds.
Note that there is an upward sloping supply curve,
a downward slope in demand curve,
and an equilibrium interest rate of,
in this case, eight percent,
where the supply and demand curves cross.
The theory of loanable funds is based on the assumption that households supply funds for
investment by abstaining from consumption and accumulating savings over time.
And here, the upward sloping supply curve of
loanable funds reflects the idea that households prefer
present consumption to future consumption and therefore must be
paid an interest rate bribe to induce them to save rather than consume.
In this figure, you can see that the higher the interest rate,
the larger the amount households are willing to save.
Now on the demand side,
it is businesses that demand loanable funds to build
new plants or warehouses or to purchase machinery and equipment.
So why do you think this curve is downward sloping?
A minute now to stop and think about this.
Well the idea here is that,
other things equal, there will be more potential investments that will be
profitable at lower interest rates than at higher interest rates.
Let me illustrate this by recalling
our earlier example of the ugly duckling car rental company.
In that example the company bought a used car for $10,000 earned
a net rental of twelve hundred dollars and
wound up with a 12 percent rate of return on its investment.
Now suppose the company wants to borrow
some money from the market for loanable funds to buy
an identical used car and it projects an identical rate of return on its investment.
The interest rate is 10 percent,
it will surely borrow the money as the rate of
return that it can earn using the funds exceeds that.
However, suppose the interest rate is 15 percent. What will it do?
That's right, it won't borrow the money and it therefore won't make the new investment.
More broadly, this example not only shows us why
the demand curve for loanable funds is downward sloping,
it also helps explain equilibrium in the market.
Where the supply of funds equals the demand for funds.
In our figure, equilibrium occurs at an interest rate of eight percent.
Suppose the market rate of interest were instead 10 percent.
In that case, the supply of funds would exceed the demand for funds because
not enough businesses could find investments
capable of generating at least a 10 percent rate of return.
Because of this surplus of funds lenders would have to lower the interest rate.
In contrast, if the interest rate were 6 percent in
this market there would be plenty of businesses demanding the funds,
however there wouldn't be enough households willing to forgo
present consumption to meet that demand.
The result, excess demand would bid up
the interest rate and drive that rate back to where the supply and demand curves cross.
Of course from this discussion,
we can see then that the market interest rate serves two important functions.
First, it rations out society's scarce supply
of capital goods for the uses that have the highest rates of return.
And second, it induces people to sacrifice
current consumption in order to increase the stock of capital.
Dr. Peter NavarroProfessor
