Capital formation is a process that is vital to help facilitate economic growth. With an upward trend in economic growth, new jobs can be created, technology, innovation, and etc. With regards to the concept of Capital, it comprises many items, viz: Money, equipment, Real Estate, machinery, etc etc. With regards to this article, the focus of Capital Formation will be simply cash and its equivalents.
How is Capital Formed?
It all starts with human action. Humans seek to improve their circumstances via voluntary exchange. Voluntary exchange takes place, as the actors in the marketplace continue to produce and trade. In this process, humans will seek to place some “capital” aside. They may place it in a mattress, coffee can, a hole in the backyard, a pillow, or with a financial intermediary. Some examples of a financial intermediary are as follows: A bank, credit union, investment brokerage, and insurance company. Once the actors begin the process of production, some of the “savings” goes into the bank. This is the start of the process on how capital is formed.
The Role of the Financial Intermediary
As actors in the market begin to produce and engage in Voluntary exchange, the money is stored in a financial intermediary. Financial intermediaries, in turn, seek to “grow” their capital base. This base comes from the depositors. The financial intermediary seeks to market loans to others in the market place. These loans, limited to the scope of our analysis, are used to help business owners acquire capital equipment, fund labor, purchase real estate, and other economic inputs.
The Natural Rate of Interest
The concept of the natural rate of interest is derived from the Law Of Marginal Utility. In short, it is the ratio between present goods and future goods. With that ratio, and other factors(risk, etc), the financial intermediary charges interest for borrowers. Another point to add: it is indicative of the temporal preference of things on the individual’s utility ranking. Each of our actions precede the next action. Those actions we select first are preferred over the latter actions. If those actions involve some voluntary exchange, with prices used in the exchange, the interest rate can be calculated…somewhat. In our analysis, the actor simply defers his capital for present consumption and places it into a financial intermediary. For those who use the bank to store capital, the bank provides an interest rate on those monies. This rate of interest acts as a signal to the actors in the marketplace, as it is tantamount to a price. The rate of interest will fluctuate as the actors are constantly moving towards an over all equilibrium. In an un hampered market, all the actors in this scenario, seek to balance present needs vs future needs.
With the process of capital formation, it begins with productivity. The actors involved in the labor market place aside some of their earnings, as they prefer to use that portion for future consumption. In turn, financial intermediaries loan out monies from this capital base to business owners, individuals and the like to help them acquire assets.
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