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Social Sci LibreTexts

34.1: Interest

Defining Capital

In economics, capital references non-financial assets used in the production of goods and services.

learning objectives

  • Define and explain capital.

Capital

In economics, capital (also referred to as capital goods, real capital, or capital assets ) references non-financial assets used in the production of goods and services. Capital is important because it is a significant factor in the creation of wealth.

Capital goods are used in the production process and may depreciated through accounting practice to incorporate utilization, though they are not consumed. It is possible for capital goods to be maintained or regenerated depending on the type of capital.

 

Classifications of Capital

In a broad sense, capital can be divided into two categories:

  • Physical Capital: capital that must be produced by human labor before it can become a factor of production (also referred to as manufactured capital). Examples include machinery and buildings.
  • Natural Capital: a factor of production that occurs naturally in the environment; for example, land or minerals.

Fundamentally, capital is any product that is produced and has the ability to enhance a person’s power to perform work that is economically useful. For example, roads are capital for individuals who live in a city.

Capital is directly impacted by both interest and profit. Interest is a fee that is paid by a borrower of assets. It is a form of compensation for the use of the assets. Commonly, it is the price that is paid for the use of borrowed money. Profit is the accumulation of capital, which is the driving force behind economic activity. Interest allows capital to be obtained, while profit is the accumulation of the capital.

 

Features of Capital

There are certain features that determine whether a good is considered capital. These features include:

  1. the good can be used in the production of other goods (this makes it a factor of production),
  2. the good is not used up immediately in the process of production, unlike intermediate goods or raw materials, and
  3. the good was produced.

 

Modern Types of Capital

There are detailed classifications of capital which include the following types:

  • Financial Capital is capital that is liquidated as money for trade, and owned by legal entities. It is a form of capital assets that is traded in financial markets. The value of financial capital is based on the market perception of expected revenues and risk.
  • Natural Capital is capital that occurs naturally in the environment and is protected because it supports human life. Examples of natural capital include land and water.
  • Social Capital is capital that is captured as goodwill or brand value. It is the general concept of inter-relationships between humans have money-like value that motivates actions.
  • Instructional Capital is capital that is defines as the aspect of teaching knowledge and transferring knowledge that is not inherent in individual or social relationships.
  • Human Capital is capital that includes social, instructional, and individual human talent combined together. As a term, it is used to define balanced growth where the goal is to improve human capital and economic capital equally.

 

Interest Rates and Economic Rationale

Economic rationale, the reasons or thought processes that impact economic decisions, is influenced substantially by the interest rate.

learning objectives

  • Define and explain the relationship between interest rates and economic rationale.

Economic Rationale

Rationale is defined as an explanation of the basis or fundamental reasons for something. In economics, rationale are the reasons or thought processes that impact economic decisions. The interest rate is one of the primary influences on economic rationale.

Interest Rate

The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender (creditor). It is the percent of principal paid a certain amount of times per period.

Impact of the Interest Rate

The interest rate guides economic rationale because it is a vital tool of monetary policy. The interest rate is taken into account when dealing with economic variables such as investment, inflation, and unemployment. Central banks usually reduce the interest rate to increase investment and consumption in the country’s economy. The interest rate directly impacts economic choices such as spending, investment, and consumption.

tes-from-1967-to-2003-grid.png 

Interest Rates: This graph shows the fluctuation in interest rates in Germany from 1967 to 2003. The interest rates reached 14% in 1969 and lowered to 2% by 2003. The interest rate in an economy directly impacts economic choices including spending, investment, and consumption.

Interest rates also influence inflationary expectations. People form an expectation of what will happen to inflation in the future. The current and projected interest rates are influential in these economic expectations. Investments are made based on the nominal interest rate and the degree of risk involved. Low interest rates are enticing, but can be problematic if an economic bubble forms. For example, low interest rates can lead to large amounts of investments poured into the real-estate market and stock market. When these bubbles pop, the investments fail, resulting in large unpaid debts and financial bankruptcy for individuals and banking institutions.

When interest rates increase, investments decrease, which causes the national income to fall. High interest rates do encourage more savings, which over time leads to more investment and higher levels of employment to meet production needs. Higher rates discourage economically unproductive lending such as consumer credit and mortgage lending.

The interest rate also directly impacts money and inflation because the government can affect the markets and alter the total of loans, bonds, and shares that are issued. When the interest rate is lower, it usually increases the broad supply of money. An increase in the money supply leads to inflation.

 

Key Points

  • Fundamentally, capital is any product that is produced and has the ability to enhance the power of an individual to perform economically useful work.
  • Capital is directly impacted by both interest and profit. Interest allows capital to be obtained, while profit is the accumulation of the capital.
  • Features that determine whether a good is capital include: 1) the good can be used in the production of other goods (this makes it a factor of production ), 2) the good is not used up immediately in the process of production, unlike intermediate goods or raw materials, and 3) the good was produced.
  • Types of capital include: physical, financial, natural, social, instructional, and human.
  • The interest rate is the rate at which interest is paid by a borrower (debtor) for the use of money borrowed from a lender (creditor).
  • The interest rate guides economic rationale because it is a vital tool of monetary policy.
  • The interest rate directly impacts economic choices such as spending, investment, and consumption.
  • When interest rates decrease, investment and spending increase. When interest rates increase, investments decrease which causes the national income to fall.

Key Terms

  • capital: Already-produced durable goods available for use as a factor of production, such as steam shovels (equipment) and office buildings (structures).
  • depreciate: To reduce in value over time.
  • interest rate: The percentage of an amount of money charged for its use per some period of time (often a year).
  • monetary policy: The process by which the central bank, or monetary authority manages the supply of money, or trading in foreign exchange markets.
  • inflation: An increase in the general level of prices or in the cost of living.

 

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