Understanding the Capital Market
- The capital market brings together savers (suppliers of capital) and investors (demanders of capital).
- The interest rate acts as the price of capital, balancing the demand and supply of funds.
- This market determines how financial resources are allocated across the economy.
The Demand for Capital
Who Demands Capital?
- Businesses: To invest in equipment, technology, R&D, and expansion.
- Governments: To finance infrastructure, education, and defense through bond issuance.
- Households: To fund major purchases such as homes, cars, or education (mainly in consumer credit markets).
Determinants of Capital Demand
- Interest Rates: Inverse relationship—lower interest rates encourage borrowing; higher rates discourage it.
- Expected Rate of Return: If anticipated profits from capital exceed the cost of borrowing, demand rises.
- Business Confidence: Optimistic expectations about the economy increase investment demand.
- Technology and Innovation: New technologies create opportunities that require capital investment.
- Tax Policy: Incentives like depreciation allowances and investment credits boost demand for capital.
The Supply of Capital
Who Supplies Capital?
- Households: Save income and invest through banks, bonds, or stock markets.
- Businesses: Reinvest profits (retained earnings) instead of distributing them as dividends.
- Foreign Investors: Provide capital through foreign direct investment (FDI) and portfolio flows.
Determinants of Capital Supply
- Interest Rates: Direct relationship—higher rates encourage more saving and capital provision.
- Income Levels: Higher disposable incomes lead to increased savings and capital availability.
- Consumer Preferences: Societies with a stronger preference for future consumption tend to save more.
- Government Fiscal Policy: Budget surpluses increase national saving; deficits reduce capital supply.
- Financial System Efficiency: Well-functioning markets enhance the mobilization and allocation of savings.
Equilibrium in the Capital Market
Interest Rate as the Equilibrating Mechanism
- At the equilibrium interest rate, the quantity of capital demanded equals the quantity supplied.
- Excess Demand (Shortage): Occurs when interest rates are too low, leading to more borrowing than saving.
- Excess Supply (Surplus): Occurs when interest rates are too high, discouraging borrowing and leaving savings unused.
Shifts in Demand and Supply
- Demand Shift: A rise in business optimism or technological breakthroughs increases demand for capital, pushing interest rates up.
- Supply Shift: An increase in national savings or foreign capital inflows raises supply, lowering interest rates and stimulating investment.
Interplay of Capital Demand and Supply in Economic Development
The interaction between the demand and supply of capital determines the cost of borrowing and the volume of investment in the economy. A well-balanced capital market enables efficient resource allocation, promotes entrepreneurship, and drives sustainable growth. Policymakers must nurture both sides—encouraging savings while creating a favorable climate for productive investment.