15.5 Equilibrium in the Capital

Market

We have discussed how the economy’s demand for capital is related to
the interest rate; a rise in the interest rate leads firms to reduce their
desired capital stock and thus reduce their need for financial capital. We
have also discussed how the economy’s supply of capital is related to the
interest rate; a rise in the interest rate leads households to increase their
desired saving and thus provide more financial capital. We are now ready
to put these two sides of the capital market together to examine market
equilibrium.

The Equilibrium Interest Rate

There is an important difference between the analysis of individual firms
and households on the one hand, and the analysis of the overall capital
market on the other. Individual firms and households take the interest
rate as given because they are so small relative to the entire economy that
their own actions have no effect on the interest rate. For firms and
households, the interest rate is exogenous. In the overall capital market,
however, the interest rate is determined by the interaction of demand and
supply—that is, the interest rate is endogenous. This important distinction
is analogous to the one that exists in any competitive market; firms face a