Physical Capital and Financial Capital - Essay Example

Macroeconomics SECTION ONE: Table 2 Determinants of Aggregate Supply (aggregate supply curve shifts when these change) Determinant AS Increases AS Decreases Changes in Input Prices Decrease Increase Changes in Productivity *********** ************ - Technology Increase Decrease - Changes in human capital Increase Increase Changes in Taxes and Regulations ************* ************** - Tax rates Decrease Increase - Subsidies Increase Decrease - Changes in burdensome regulations Decrease Increase Change in Market Power Increase Decrease Changes in Business or Inflation Expectations Increase Decrease - Business expectations Increase Decrease - Inflation expectations Decrease Increase Table 1 Determinants of Aggregate Demand (aggregate demand curve shifts when these change) Determinant AD Increases AD Decreases Consumer Spending Increase Decrease - Wealth Increase Decrease - Consumer expectations Increase Decrease - Household debt Increase Decrease - Taxes Decrease Increase Investment **************** ******************** - Interest rates Decrease Increase - Expected rate of return on investment Increase Decrease Government Spending Increase Decrease Net Exports ****************** ********************* - Exports Increase Decrease - Income in other countries Increase Decrease - Exchange rate changes Decrease Increase - Imports Decrease Increase - Income in the United States Decrease Increase - Exchange rate changes Increase Increase Note: In the red above, an increase in wealth makes AD increase; a decrease in wealth makes AD decrease. This is how you should format each table. SECTION TWO a) Physical capital differs from financial capital in a number of ways. By definition, physical capital is an already-manufactured tangible asset that is used in production. On the other hand, financial capital refers to equity that is used by business owners to purchase resources that are required in producing goods and services. Different from financial capital, physical capital can be acquired by building it, purchasing it or renting it. Financial capital can be acquired through borrowing and selling of ownership stake within an organization. Examples of financial capital include bank loan and corporate bonds, while that of physical capital include motor vehicle and machinery. b) The distinction between gross investment and net investment is based on capital depreciation. Gross investment refers to total amount of investment that does not incorporate any depreciation while net investment refers to investment that incorporates depreciation. Therefore net investment can simply be defined as gross investment less capital depreciation. The difference between gross investment and capital investment can be illustrated mathematically as follows. Net Investment = Gross Investment – Depreciation Gross investment = Net investment + Depreciation c) The three main types of markets for financial capital include Loan markets Stock market Bond market d) The price of a financial asset and interest rate has an inverse relationship. The prices of financial asset do always increase with decrease in interest rate. This can be explained well by considering the relationship of a financial asset such as bond with its interest rate. For example, let’s assume company X issues a new bond that has a face value of $1000 with an interest rate of 7%. If in the same year the general interest rates increases to about 8%, buyers will not be willing to pay the $1000 face value with an interest rate of 7%. Therefore, in order to sell the bond, company X will have to issue its bond at a lower price, that is, at a discount that will enable the new bond holder to generate an 8% interest. In this scenario, the price of the bond will fall to approximately $ 875. Similarly, if the interest rate falls to 6%, the price of the bond will be much higher than $1000. The bond will be valued at $1166. This is illustrated in the diagram below. e) When firms are involving in decisions to make investment, they normally consider a number of factors. In order to make an effective decision, they normally consider the scale of the investment, that is, how big and costly is the investment. The firms therefore do always make investment decisions by determining if they can afford the investment. Another factor that firms usually consider when making investment decisions is the period the investment will take before it begins to generate returns. The firms, when making investment decisions, usually prefer investment that will take shorter time to mature. The period it will take to repay the investment and the amount of profits expected are also essential factors to consider in investment decision making. f) The demand for loanable funds is determined by the interest rates and profit expected from the investment. Interest rates and the demand for loanable funds are inversely related, that is, when interest rates are high few loanable funds are demanded. This can be illustrated graphically as follows. Interest rates D1 Quantity of loanable funds The demand for credits can change due to an increase or decrease of loanable funds. Few loanable funds will be demanded if the interest rates are high. The movement therefore along the demand curve for loanable funds explains this event. The demand for loanable funds will also increase if there is an increase in expected profits. The increase in expected profit causes the demand curve for loanable funds to shift to the right. g) Households do always make saving decision by considering the following five factors. Their saving decision normally depends on real interest rate, disposable income, wealth, default risk and expected income. Households do always enhance their saving if there is an increase in disposable income, increase in interest rate, decrease in expected income, decrease in wealth and decrease in default risk. h) The supply for loanable funds is determined by interest rates, wealth, default risk, disposable income and income expected in future. Interest rates and supply for loanable funds are positively related. When interest rates are high more loanable funds will be supplied in the loanable funds market. This can be illustrated graphically as follows. i) Interest rates S1 S1 Quantity for loanable funds Note: SC is the supply for loanable funds or credit DC is the demand for loanable funds or credit r1 is the interest rate before budget deficit r2 is the new interest rate after budget deficit. j) Crowding out effect is a reduction in investment that normally occurs when there is an increase in budget deficit. The increased budget deficit enhances the demand for credit and as a result, the interest rate increases. The increased interest rate reduces or crowds out investments. k) Ricardo-Barro effect highlights that the crowding out effect cannot only be described by looking at the impact of budget deficit on demand for credits, but also on household saving. It claims that the budget deficits do always make households to enhance their savings so as to pay the high taxes that might be needed in future to pay back the debt used to finance the deficit. The supply of credits will therefore be enhanced by the saving increase. The increase in credit supply will offset the increased interest rate caused by an increase in demand for credit. The amount of crowding out in Recardo-Barro effect will be much less since the interest rates increases with a few margin. l) Loanable funds flow between nations due to the fact that savers are looking for interest rates that are much high while borrowers are looking for interest rates that are very low. m) If a nation has a shortage of loanable funds, it will borrow from other countries thus becoming a global borrower. n) If a nation has an excess of loanable funds, it will loan the surplus to other countries, thus becoming a global lender. o) The demand for loanable funds is usually enhanced by budget deficit. The increase in demand for credit, in an open economy, usually implies that a nation will lend less to other nations or borrow a lot of funds from other nations. Therefore, the budget deficit is usually financed by these changes in borrowing and lending. p) Initial capital = $400,000 Additional capital = $500,000 Gross Investment = $400,000+ $500,000 = $900,000 Depreciation on initial capital = $100,000 Net Investment = $900,000-$100,000= $800,000 q) The value of Michael’s capital at year ending 2010 is $800,000 r) Work cited Taylor, John B. Principles of Economics: Global Financial Crisis Edition. Mason, Ohio: South-Western, 2010. Print. Macdonald, Nadia. Macroeconomics and Business: An Interactive Approach. London: International Thomson Business, 1999. Print. Read More