15.1 A Brief Overview of the Capital

Market

Firms require physical capital to produce their goods and services. Their
purchase of new capital equipment is called investment in physical capital.
They also require working capital—the funds necessary to purchase
material inputs and pay workers while the goods are being made and
even while the firm is waiting to be paid for its sales.

We saw in Chapter 7 that firms finance their activities in one of four
ways. First, they use profits that are not remitted to shareholders—these
are called retained earnings. Second, they borrow from commercial banks
or other financial intermediaries, such as credit unions and trust
companies. Third, they issue bonds (an IOU) and thereby borrow directly
from lenders. Fourth, they issue and sell stock (a share of the company)
directly to shareholders. However firms choose to finance their activities,
their demand for financial capital comes from their demands for physical
capital and working capital.

The supply of financial capital comes mostly from households’ saving
decisions. Every year, millions of households decide how much of their
after-tax income to save. These funds are often deposited into various
types of accounts at commercial banks, each of which is a loan from a
household to the bank. Sometimes the funds are used to buy bonds so

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