[MUSIC] In the ugly duckling example, I mentioned the word depreciation but didn't really define it. It's a very, very important concept in the analysis of capital, so let me do that now. Both investment and depreciation are flow concepts, meaning that they are measured per unit of time. This is in contrast to capital, which is a stock concept, meaning that capital is measured at a given point in time. Depreciation is an estimate of the loss in the dollar value of a capital good, due to obsolescence or wear and tear during a period of time. And corporations are allowed to treat depreciation as an expense on their taxes, just like other expenses, like labor costs and raw materials. When depreciation over a period of time exceeds investment over the same period of time, the capital stock will decrease. Whereas if investment exceeds depreciation, the capital stock will increase. For example, suppose the firm ends its fiscal year with a capital stock of $1 million. And then over the course of the current year, invests $100,000 in new plant equipment. At the same time, it incurs depreciation of 200,000 dollars. What is it's capital stock at the end of the current year? [SOUND] That's right, it's 900,000 dollars. Now that we understand both the interest rate and the rate of return, let's next come to understand how the interaction of these two variables determine investment decisions in a market economy. In a nutshell, we are about to see that firms will demand loanable funds to invest in new projects, so long as the rate of return on capital is greater than or equal to the interest rate paid on funds borrowed. Let me demonstrate this for you by first introducing the theory of loanable funds. This market illustrates the market for loanable funds. Note that there is an upward sloping supply curve, a downward sloping demand curve, and an equilibrium interest rate of, in this case, 8%, where the supply and demand curves cross. The theory of loanable funds is based on the assumption that households supply funds for investment by abstaining from consumption and accumulating savings over time. The upward sloping supply curve of loanable funds, reflects the idea that households prefer present consumption to future consumption. And therefore must be paid an interest rate bribe to induce them to save rather than consume. You can see the higher the interest rate, the larger the amount households are willing to save. On the demand side, it is businesses that demand loanable funds to build new plants or warehouses, or to purchase machinery and equipment. Why do you think this curve is downward sloping? The idea here is that, other things equal. There will be more potential investments that will be profitable at lower interest rates than at higher interest rates. Let me illustrate this by recalling our earlier example of the ugly duckling car rental. In that example, the company bought a used Ford for $10,000, earned a net rental of $1,200 and wound up with a 12% rate of return on its investment. Now, suppose the company wants to borrow some money from the market for loanable funds to buy an identical used ford. And it projects an identical rate of return on its investment. If the interest rate is 10%, it will surely borrow the money, because the rate of return that it can earn using the funds exceeds that. However, suppose the interest rate is 15%, what will it do? That's right. It won't borrow the money, and it therefore won't make the new investment. This example, not only shows us why the demand curve for loanable funds is downward sloping, it also helps explain equilibrium in the market, where the supply of funds equals the demand for funds. In our figure, equilibrium occurs at an interest rate of 8%. But suppose the market rate of interest were instead 10%. In that case, the supply of funds would exceed the demand for funds. Because, not enough businesses could find investments capable of generating at least a 10% rate of return. And because of this surplus of funds, lenders would have to lower the interest rate. In contrast, if the interest rate were 6% in this market, there would be plenty of businesses demanding the funds. However, there wouldn't be enough households willing to forego present consumption to meet that demand. The result? Excess demand would bid up the interest rate and drive that rate back to where the supply and demand curves cross. From this discussion, we can see then that the market interest rate serves two functions. It rations out society's scarce supply of capital goods for the uses that have the highest rates of return. And it induces people to sacrifice current consumption in order to increase the stock of capital.
