[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

want to save, you can put money into a savings account at a bank. This earns interest
and is very safe, because the federal government insures savings accounts with
balances up to $100,000. The tremendous boom in the stock market in the 1990s
encouraged many people to put some of their savings into stocks. Stocks earn a
higher return on average than savings accounts, but they are much riskier. The stock
market can go down as well as up. Real estate has also been an attractive place to put
savings, but it too is risky. Rather than discussing the various savings options that
are available to households, our focus in this chapter is on the broad outlines of the
capital market and the role played by the interest rate in affecting saving decisions.
Demand in the Capital Market
Our goal here is to understand how the supply of savings by households and the
demand for savings by firms result in a market equilibrium. In the preceding sections
we worked through the supply side of the market. Now we turn to demand. The
demand side of the capital market is driven by firms that borrow the savings of
households to fund their purchases of capital goods—the machines, tools, buildings,
and other equipment used in the production process. We therefore begin our
analysis with firms’ demand for capital goods.
Applying the same principle we used earlier to derive the demand for labor, we
know that firms will demand capital (capital goods) up to the point at which the value
of the marginal product of capital is equal to the price. The marginal product of capital
is just the additional output obtained if one more unit is employed. It is the extra
output obtained by adding another machine. But what is the price of capital?
A quick answer is that the price of a piece of equipment is simply what it costs
to buy it. If a new computer server to handle Internet orders costs the firm $20,000,
isn’t that the price of this particular piece of capital? The answer is no—and to see
why more is involved, let’s think about the decision of a new start-up company as it
evaluates whether to buy this computer. To keep things simple, suppose Andrea and
Bryan, the company founders, plan to sell the server after one year for $12,000. They
can borrow the $20,000 to buy the server from their bank, and the bank charges
them interest on this loan. Let’s suppose for our example that the interest rate the
bank charges is 5 percent. What has it cost them to use the equipment?
Andrea and Bryan pay $20,000 for the server. At the end of the year, they sell the
server for $12,000, but they also have to repay the bank. Since the bank charged them
5 percent interest, at the end of the year they owe the bank $21,000 (the $20,000 they
borrowed plus $1,000 in interest). So the net cost of using the server is $21,000 −
$12,000 = $9,000. A critical part of this cost is the interest Andrea and Bryan had to
pay the bank. If the interest rate had been 10 percent, the cost of the computer would
have been $10,000 ($20,000 + $2,000 − $12,000, since interest now totals $2,000).
The user cost of capital increases when the interest rate rises.
The interest rate would have played exactly the same role if Andrea and Bryan
had not needed to borrow from the bank. Suppose they had savings of their own that
they could use to purchase the computer. When they use their own savings to buy the
computer, there is an opportunity cost associated with the purchase. Andrea and
Bryan could have left their $20,000 in the bank. If the interest rate is 5 percent, they
200 ∂ CHAPTER 9 CAPITAL MARKETS