In this chapter, we look first at firms’ demand for physical capital, which
leads us to understand their demand for financial capital. As we will see,
the interest rate plays an important role in determining how much capital
is demanded by firms. We then examine households’ saving decisions
and thus their supply of financial capital. The interest rate also plays an
important role in determining how much financial capital households
want to supply. Once we understand the demand and supply for financial
capital, we will be ready to put the two sides of the capital market
together to determine the equilibrium “price” of financial capital—the
interest rate. Finally, we will look at how economic events or policies can
affect the equilibrium levels of investment, saving, and the interest rate.
Before beginning our analysis of the demand for capital, it is necessary to
clarify one important difference between labour and physical capital as
factors of production. When economists speak of the demand and supply
for labour, they are referring to the flow of labour services. For example, a
firm considers hiring the services of a worker for a month, after which the
firm and the worker go their separate ways. In contrast, when a firm -
considers its demand for physical capital, it is considering purchasing a
new piece of equipment and thereby adding to its stock of capital. This
piece of capital equipment will usually deliver services to the firm over
many years before it is eventually discarded because it has worn out or
become obsolete. The durability of physical capital means that we must
distinguish between the stock of capital and the flow of services that it
delivers. We need a way to evaluate the flow of services that a piece of
capital equipment delivers for many years into the future. Only then can