2. The market for capital Firms require capital to invest in productive opportunities. The best firms with the most profitable opportunities can attract capital away from inefficient firms with less profitable opportunities. Investors supply firms with capital at a cost called the interest rate. The interest rate that investors require is determined by several factors, including the availability of production opportunities, the time preference for current consumption, risk, and inflation The following graph shows the supply of and demand for capital in a market. The upward-sloping supply curve suggests that investors are willing to invest more (delay more current consumption) in exchange for higher interest rates. The downward-sloping demand curve suggests that borrowers of capital (companies) will fund their most profitable opportunities first and their least profitable opportunities later. This fact explains why they are willing to pay a rather high price (interest rate) for capital initially, but also why their appetite for capital decreases over time. On the following graph move the black X to show the market interest rate. 16 Supply Equilibrium Demand 9 8 4 CAPITAL (Billions of dollars) Suppose the Federal Reserve (the Fed) decides to tighten credit by contracting the money supply. Use the following graph by moving the black X to 1 show what happens to the equilibrium level of borrowing and the new equilibrium interest rate 16 S1 New Equilibrium 8 CAPITAL (Billions of dollars) Which tend to be more volatile, short- or long-term interest rates? Long-term interest rates Short-term interest rates If the inflation rate was 2.00% and the nominal interest rate was 4.20% over the last year, what was the real rate of interest over the last year? Disregard cross-product terms; that is, if averaging is required, use the arithmetic average. 2.20% 0 275% 1.87% 2.53%