Capital Markets: Where Money Goes to Work
The Big Picture: Money Has a Job Too!
Imagine you have a piggy bank full of coins. Those coins are just sitting there, doing nothing. But what if you could lend them to your friend who wants to start a lemonade stand? Your friend uses your money to buy lemons and sugar. Later, they pay you back—plus a little extra as a thank-you gift!
That’s exactly what capital markets do, but on a HUGE scale. Banks, businesses, and even countries borrow and lend money to build things, create jobs, and grow.
The Loanable Funds Market: The Big Money Pool
What Is It?
Think of a giant swimming pool. On one side, people throw money IN (these are savers). On the other side, people take money OUT (these are borrowers).
Savers = People, banks, or governments who have extra money they don’t need right now.
Borrowers = Businesses wanting to build factories, students paying for college, families buying homes.
graph TD A["💰 Savers"] -->|Deposit Money| B["🏊 Loanable Funds Pool"] B -->|Lend Money| C["🏗️ Borrowers"] C -->|Pay Back + Interest| B B -->|Return + Interest| A
How Does the Price of Borrowing Get Decided?
The “price” of borrowing money is called the interest rate.
- Lots of savers, few borrowers? Interest rates go DOWN (money is easy to get).
- Few savers, lots of borrowers? Interest rates go UP (money is hard to get).
It’s just like buying apples:
- Too many apples at the market? Price drops.
- Not enough apples? Price goes up.
Simple Example
Your town has $10,000 in savings. Three businesses want to borrow:
- Pizza Shop needs $3,000
- Toy Store needs $5,000
- Bike Repair needs $4,000
That’s $12,000 in demand but only $10,000 available! Interest rates rise until one business decides it’s too expensive and backs out.
Real vs. Nominal Interest Rate: The Sneaky Inflation Trick
The Problem with Numbers
Your dad says, “I’ll give you $10 today OR $11 next year. Which do you want?”
Seems easy, right? $11 is more! But wait…
What if candy bars cost $1 today but will cost $1.20 next year? Let’s check:
- Today: $10 buys 10 candy bars
- Next year: $11 buys only about 9 candy bars!
You actually got LESS, even though the number was bigger. Sneaky, right?
Two Types of Interest Rates
| Type | What It Means | Example |
|---|---|---|
| Nominal | The number you see on paper | “5% interest” |
| Real | What you ACTUALLY get after prices rise | Maybe only 2% |
The Magic Formula
Real Interest Rate = Nominal Interest Rate − Inflation Rate
Example:
- Bank offers 6% interest (nominal)
- Prices rise 4% (inflation)
- Your REAL gain = 6% − 4% = 2%
You only got 2% richer in what you can actually BUY!
Why This Matters
When people talk about interest rates, always ask: “Real or nominal?” Otherwise, you might think you’re getting a great deal when you’re actually losing!
Interest Rate Determination: Who’s the Boss?
Three Big Players
Interest rates don’t magically appear. They’re decided by:
- The Central Bank (like the Federal Reserve in the US)
- Supply of Money (how much is available to lend)
- Demand for Money (how much people want to borrow)
How the Central Bank Controls Rates
Think of the central bank as the manager of the swimming pool. They can:
- Add more water (print money) → Interest rates go DOWN
- Drain some water (remove money) → Interest rates go UP
graph TD A["Central Bank"] -->|Adds Money| B["More Funds Available"] B --> C["Interest Rates Fall"] A -->|Removes Money| D["Fewer Funds Available"] D --> E["Interest Rates Rise"]
Other Things That Move Rates
| Factor | Effect on Rates |
|---|---|
| Economy booming | Rates rise (everyone wants to borrow) |
| Economy slowing | Rates fall (fewer borrowers) |
| High inflation | Rates rise (to cool things down) |
| Government borrowing a lot | Rates rise (more competition) |
Real-Life Example
In 2020, when COVID hit, central banks around the world LOWERED interest rates to almost zero. Why? They wanted people and businesses to borrow money to keep the economy going!
Time Value of Money: A Dollar Today vs. Tomorrow
The Golden Rule
A dollar today is worth MORE than a dollar tomorrow.
Why? Three reasons:
- You can invest it and earn interest
- Prices rise (inflation eats your money)
- Risk (what if the person never pays you back?)
Present Value: Bringing Money Back in Time
If someone offers you $100 in one year, what’s that worth TODAY?
Formula: Present Value = Future Amount ÷ (1 + Interest Rate)
Example:
- You’ll get $100 next year
- Interest rate is 10%
- Present Value = $100 ÷ 1.10 = $90.91
So $100 next year is only worth about $91 today!
Future Value: Sending Money Forward in Time
What if you invest $100 today at 10% interest?
Formula: Future Value = Present Amount × (1 + Interest Rate)
Example:
- You invest $100 today
- Interest rate is 10%
- Future Value = $100 × 1.10 = $110
Your $100 becomes $110 in one year!
Compounding: The Snowball Effect
What if you leave money for MULTIPLE years?
Year 1: $100 × 1.10 = $110 Year 2: $110 × 1.10 = $121 Year 3: $121 × 1.10 = $133.10
Your money keeps growing on TOP of the growth! Einstein supposedly called compound interest “the eighth wonder of the world.”
Investment Decisions: Should You Say Yes or No?
The Big Question
A business owner asks: “Should I buy this new machine for $10,000?”
To answer, they need to figure out: Will this machine make me MORE than $10,000 over time?
Net Present Value (NPV): The Ultimate Test
NPV = (Present Value of All Future Benefits) − (Cost Today)
If NPV is POSITIVE → Good investment! Do it! If NPV is NEGATIVE → Bad investment! Don’t do it!
Example: The Cookie Machine
| Item | Amount |
|---|---|
| Machine cost today | $5,000 |
| Profit Year 1 | $2,000 |
| Profit Year 2 | $2,500 |
| Profit Year 3 | $2,500 |
| Interest rate | 10% |
Step 1: Convert future profits to present value
- Year 1: $2,000 ÷ 1.10 = $1,818
- Year 2: $2,500 ÷ 1.21 = $2,066
- Year 3: $2,500 ÷ 1.33 = $1,880
Step 2: Add them up = $5,764
Step 3: Subtract cost = $5,764 − $5,000 = $764 (Positive!)
Decision: Buy the machine!
Interest Rates and Investment
When interest rates are LOW:
- Borrowing is cheap
- More projects look profitable
- Businesses invest MORE
When interest rates are HIGH:
- Borrowing is expensive
- Fewer projects make sense
- Businesses invest LESS
graph TD A["Low Interest Rates"] --> B["Cheaper to Borrow"] B --> C["More Investment"] C --> D["Economy Grows"] E["High Interest Rates"] --> F["Expensive to Borrow"] F --> G["Less Investment"] G --> H["Economy Slows"]
Putting It All Together
Capital markets are like a giant matchmaking service for money:
- Loanable Funds Market connects savers with borrowers
- Interest rates are the “price” that balances the market
- Real rates tell you what you actually gain (after inflation)
- Time value of money reminds us that money NOW beats money LATER
- Investment decisions use these ideas to pick smart projects
When you understand these concepts, you understand how money flows through the entire economy—from your piggy bank all the way to giant skyscrapers being built downtown!
Quick Recap
- Loanable Funds Market: The pool where savers and borrowers meet
- Real Interest Rate: Nominal rate minus inflation (the REAL gain)
- Interest Rate Determination: Set by central banks, supply, and demand
- Time Value of Money: A dollar today is worth more than a dollar tomorrow
- Investment Decisions: Use NPV to decide if a project is worth it
Now you’re ready to think like an economist!