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Will an increase in interest rates or an increase in the demand for physical capital increase the quantity of financial capital demanded?

When the demand for physical capital increases, the quantity of financial capital needed to pay for it also increases. Demand for financial capital is a downward sloping function of interest rates. An increase in interest rates would decrease the quantity demanded of financial capital.

All other things equal, which of the following would least likely lead to an increase in the equilibrium rate of interest?

A)	Decrease in supply of capital and an increase in demand for capital.

B)	Increase in supply of capital with no change in demand for capital.

C)	Decrease in supply of capital with no change in demand for capital.

An increase in the supply of capital, assuming no change in the demand for capital, will cause the equilibrium interest rate to fall.

Which of the following statements about individuals’ savings behavior is most accurate?

A)	Higher interest rates make individuals less willing to trade present consumption for future consumption.

B)	Individuals tend to draw down their savings when they anticipate a decline in their incomes.

C)	Expected increases in income encourage individuals to save less.

Individuals generally save less (and borrow more) when they expect to earn higher incomes in the future. Conversely, they increase their savings when they expect lower future incomes, such as when workers approach retirement. Higher interest rates encourage savings, or trading present consumption for future consumption. Increases in current incomes encourage savings, while decreases in current incomes discourage savings.

A)	Decreases in individuals’ expected future incomes.

B)	A larger number of attractive investment opportunities.

C)	A higher market rate of interest.

The supply of capital is the savings of individuals. The three primary factors that affect savings behavior are interest rates, current incomes, and expected incomes. The number of attractive investment opportunities (i.e., positive net present value projects) will influence the demand for capital.

The decision whether to add capital equipment to the production process should be based on:

A)	future value, using the cost of financial capital as a benchmark.

B)	present value, using the cost of financial capital as a benchmark.

C)	present value, using the marginal revenue product of capital as a benchmark.

The marginal revenue product of capital is the prospective gain from adding capital to the production process. Since these gains occur many years into the future, they must be discounted at the cost of financial capital to obtain a present value. It is this present value that is compared with the cost of the project to determine whether or not the project should be accepted.

One of the key differences between the decisions to add labor or capital to the production process is that the returns to labor:

A)	are relatively immediate, but those to capital may be years into the future so they must be evaluated as present values.

B)	are relatively immediate, but those to capital may be years into the future so they must be evaluated as future values.

C)	must be projected into the future and evaluated as present values, while returns to capital can be evaluated immediately based upon market interest rates.

The returns to labor are relatively immediate, and can be compared with the overall wage cost of the labor. The returns from the addition of capital occur over a span of years, so must be discounted back to today and evaluated as present values versus the cost of the capital.