CFA Level 1

Macroeconomics - The Demand and Supply of Financial and Physical Capital


Physical vs. Financial Capital
The term physical capital applies to the stock of buildings, equipment, instruments, raw materials, semi-finished and finished goods in inventory, and other physical objects used by a firm to produce its goods and/or services.

Financial capital
includes the resources used to purchase those physical objects; those resources come from savings. Interest represents the price of capital; the actual market interest rate will be the rate at which the supply of capital is equal to the quantity of capital demanded.

Comparing the Future Marginal Revenue Product of Capital with Future Capital Prices
A firm needs to examine the future marginal revenue product of capital when making a decision to employ more capital. The firm converts the value of those future income streams to a value in the present. Present value is the current worth of a future income stream, discounted to reflect the fact that a dollar in the future is worth less than a dollar today. The general form of the present value calculation is:

Formula 4.2

present value = future value / (1 + r)

Where: "r" represents the relevant interest rate


Note that if future value stays the same, and interest rates decrease, future value increases. As interest rates decline, more investments of capital become profitable to the firm, and the quantity of capital demanded will increase.

Main Influences on the Demand & Supply of Capital
The main influences on the demand for capital are:

·the interest rate
·expectations concerning future business conditions - if firms believe that future business conditions will be poor, they will be less likely to make investments

The main influences on the supply of capital are:

·the interest rate
·income - as incomes increase, people generally save a larger proportion of their income
·expectations about future income - if people expect their income to decline, then they will tend to save more now so as to even out their consumption. College students will tend not to be savers, as they usually expect their future incomes to be significantly higher than the present.

The equilibrium interest rate will tend to fluctuate over time. Population changes, technological changes, and expectations are some of the factors that will influence the demand and/or supply for capital.

Renewable and Non-renewable Resources
Renewable natural resources (a form of physical capital) are those resources that tend to be replenished by nature. Examples include water or solar energy. Non-renewable natural resources are not available (for practical purposes) once they are used. Examples include natural gas, oil, and coal.

The basic principle regarding the equilibrium for non-renewable natural resources is that the price of the resource today should be equal to the present value of the next period's expected price for the same resource. Essentially, the prices for a non-renewable resource are expected to increase at a rate equal to the interest rate.

Suppose an oil producer expects prices for oil to be lower in the future. A profit-maximizing oil producer would try to sell as much oil in the present, and then invest the proceeds. If the price of oil is expected to increase at a rate greater than the interest rate, then the oil producer should let as much oil as possible stay in the ground.

Keep in mind that prices for non-renewable resources do not exactly follow this pattern because the future is always uncertain. Technological changes and political uncertainties are some of the many factors that make forecasting price changes difficult.


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