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Lecture Notes

It is important to distinguish between physical capital and financial capital. Physical capital refers to things like machines, factories, computers, and the like, which are combined with labor to produce goods and services. The productive usefulness of physical capital declines over its life through depreciation. Residential housing and government capital are included in physical capital. Financial capital refers to funds that a business raises. Financial capital can be in the form of a debt contract like a bond or loan or in the form of an equity contract like a share of stock.

2. The demand and supply of physical capital can be examined like that of any other input. The rental price of capital is the amount a rental firm charges for the use of capital equipment for a specified period of time. This price can be either explicit or implicit. Like the demand for any other input, the demand for capital is derived and depends on the marginal revenue product of capital. As capital is added to other inputs, output grows. The resulting change in output is the marginal product of capital. If it is assumed that a firm’s output is sold on a competitive market, then the marginal product of capital can be converted into revenue by multiplying it by the price of the product ( P). Thus, the MRP of capital equals MP × P. A firm will add capital until the MRP equals the rental price. At this point, profits are maximized.

The market supply of capital is the sum of the individual supply curves of all the firms renting capital. The interaction of the market demand for capital and the market supply of capital creates the equilibrium rental price. If capital is fixed in supply, its price is called economic rent.

With the addition of capital, profit maximization requires that (1) the marginal cost of output equal the marginal revenue of output, (2) the marginal revenue product of labor equal the market wage, and (3) the marginal revenue product of capital equal the rental price.

3. Discussions of financial capital usually center around stocks and bonds. The return from holding a stock is the dividend, or the amount the firm pays out to the owners of the stock each year, plus the capital gain or capital loss, the increase or decrease in the price of the stock during the year. The return and dividend can be expressed as a percent of the stock price. In this form, they are referred to as the rate of return and the dividend yield. Stocks are often judged, in part, by their price-earnings ratio, the price of the stock divided by the annual earnings per share. (Earnings is another word for the accounting profits of the firm.)

The issuer of bonds makes periodic payments of a fixed amount (the coupon) to the bondholders. At the maturity date, the face value of the bond is paid. It is important to note that there is an inverse relationship between a bond’s price and its yield. Assume that you paid $100 for a bond that, after one year, will repay you the $100 plus $5 interest. Now assume that you had to pay only $95 for the same bond. Clearly the yield is greater. Not only do you get $5 interest, but you also earn the $5 difference between the price you paid and the face value of the bond. The price of the bond went down and the yield went up.

Decisions about purchasing either physical capital or financial capital involve comparing payments of money at different points in time. A problem is that future dollars are worth less than current dollars. Ask yourself, would you rather have a dollar today or a dollar next week or next year? Future dollars must be translated into current terms before a decision can be reached. The value of the future in the present is called the present discounted value.

4. The return on stocks and bonds is also dependent on their riskiness. Most individuals are risk averse. If offered the same return on two alternative investments with different risks, most people would select the less risky of the two. Stated another way, people need greater expected returns, or the returns with the different gains or losses weighted according to how probable they are, to take on more risk. This is shown by the equilibrium risk-return relationship.

A way of dealing with risk is through portfolio diversification. This reduces the risk associated with holding any one specific stock. Index funds are an example of extensive diversification. However, diversification does not remove systematic risk, which is due to the ups and downs in the economy.

Because stock markets have many participants and ease of entry and exit, many economists argue that stock prices adjust to new information so rapidly that profit opportunities are eliminated. This is the efficient market hypothesis.

5. The exchange rate is the price of one currency in terms of another in the foreign exchange market. The standard supply and demand model can be used for studying the determination of the exchange rate.

6. The law of one price is a theory that says that exchange rates are determined so that the price for the same good is about the same in different countries. This notion is called purchasing power parity (PPP). PPP works well in the long run, but less so in the short run. Furthermore, it works better for tradable goods, where transport costs are low compared to the value of the good, than for nontradable goods, where transport costs are high.

7. In the short run, exchange rates often differ from what might be expected under purchasing power parity. The primary reason for these deviations is that the rate of return may be expected to be different in other countries. International investors are able to move money between financial assets in different countriesGlossary

capital gain: the increase in the value of an asset through an increase in its price.

capital loss: the decrease in the value of an asset through a decrease in its price.

coupon: the fixed amount that a borrower agrees to pay to the bondholder each year.

debt contract: a contract in which a lender agrees to provide funds today in exchange for a promise from the borrower, who will repay that amount plus interest at some point in the future.

depreciation: the decrease in an asset’s value over time; for capital, it is the amount by which physical capital wears out over a given period of time.

dividend yield: the dividend stated as a percentage of the price of the stock.

earnings: the accounting profits of a firm.

economic rent: the price of something that has a fixed supply.

efficient market hypothesis: the idea that markets adjust rapidly enough to eliminate profit opportunities immediately.

equilibrium risk-return relationship: the positive relationship between the risk and the expected rate of return on an asset, derived from the fact that, on average, risk-averse investors who take on more risk must be compensated with a higher return.

equity contract: shares of ownership in a firm; payments to the owners of the shares depend on the firm’s profits.

exchange rate: the price of one currency in terms of another in the foreign exchange market. We express the exchange rate as the number of units of foreign currency that can be purchased with one unit of domestic currency.

expected return: the return on an uncertain investment calculated by weighting the gains or losses by the probability that they will occur.

face value: the principal that will be paid back when a bond matures.

foreign exchange market: a market in which one currency (such as Japanese yen) can be exchanged for another currency (such as U.S. dollars).

implicit rental price: the cost of the funds used to buy the capital plus the depreciation of the capital over a given period of time.

marginal revenue product of capital: the change in total revenue due to a one-unit increase in capital.

maturity date: the date when the principal on a loan is to be paid back.

portfolio diversification: spreading the collection of assets owned in order to limit exposure to risk.

price-earnings ratio: the price of a stock divided by its annual earnings per share.

purchasing power parity: the theory that exchange rates are determined in such a way that the prices of goods in different countries are the same when measured in the same currency.

rate of return: the return on an asset stated as a percentage of the price of the asset.

rental price of capital: the amount that a rental company charges for the use of capital equipment for a specified period of time.

return: the income received from the ownership of an asset; for a stock, the return is the dividend plus the capital gain.

systematic risk: the level of risk in asset markets that investors cannot reduce by diversification.

yield: the annual rate of return on a bond if the bond were held to maturity.

Answer preview

1. Why is China still poor in per capita terms despite having the second-largest economy in the world in terms of real GDP?

It cannot be doubted that the Chinese economy has achieved impressive growth over recent times. However, despite the country having such a remarkable GDP, the ordinary Chinese is not necessarily eating or sleeping better that they were in several years ago.  Income disparity has played a significant role in having many Chinese citizens who are still struggling in poverty.  A combination of factors ranging from technology innovation, rapid economic growth, and unregulated globalization has actively promoted this trend (Xie & Zhou, 2014). These concerns if not evaluated, will ultimately affect economic prosperity and mass social unrest. This disparity can also be identified to have actively resulted from the low wage levels that exist in the country. China is widely known for its cheap labor, mainly from the…

 

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