Understanding Financial Capital's Role in Rural Economic Development - Prof. Warren Kriese, Study notes of Environmental Science

Download Understanding Financial Capital's Role in Rural Economic Development - Prof. Warren Kriese and more Study notes Environmental Science in PDF only on Docsity! Note set 6, page1 Course: Rural Economic Development and Growth (AEC 4710/6710) Instructor: Dr. Kriesel Spring Semester, 2011 TOPIC: Capital Markets in the Rural Economy (Reading: Shaffer Ch. 7) I. The Perfectly Competitive Capital Market A. Types of capital - The four basic types of capital are physical capital, human capital, natural capital, and financial capital. This section is a discussion of financial capital markets. B. Definition of a financial capital market - A capital market is defined as "a web of institutions and mechanisms by which resources are saved, investment opportunities are identified, and savings channeled to enterprises for their productive and possible use. These markets are operating efficiently if the way funds are channeled meets every opportunity for improving the overall welfare of the consumers." (page 124) C. Equilibrium - A perfectly functioning capital market is said to be in equilibrium when the supply of capital is equal to the demand for capital at a given set of prices. The price of capital is its interest rate. At equilibrium the following conditions hold: 1.The allocation of capital is efficient. This means that it is not possible to reallocate capital to improve the welfare of one party without decreasing the welfare of another party. 2.The marginal product (MP) of capital in every use is equal to the interest rate. D. Assumptions of the perfectly competitive capital market 1. Perfect foresight & information - The investor has complete knowledge of all the outcomes of his investments. Therefore he incurs no risk. In banking this means that there is no risk to the lender that the borrower will default (stop paying) on a loan. 2. No transactions costs - The lender or borrower incurs no costs in making investments. In reality, in the banking industry transactions costs could include the cost to the lender incurred when taking title to collateral forfeited by a borrower who defaulted on a loan. These costs include legal fees, payment of back taxes, etc. 3. No barriers to entry to or exit from the market. In reality there are many barriers to entry - An example of a barrier to entry to a capital market is a regulation on the minimum size of an institution. Note set 6, page2 4. There are many firms in the market, and no single firm is so big that its failure would endanger the financial system. This assumption was violated in the events leading up to 2008. If financiers think their institutions are too big to fail, then they will take on risky business. II. Components of a Capital Market A. Submarkets - Capital markets are not homogeneous but segmented into numerous submarkets. Submarkets may be defined by the following types. 1.Type of capital - Examples of types of capital include short-term, long-term, operating, real estate, commercial/industrial, and farm capital. 2.Debt or equity capital - Debt capital is obtained by borrowing. Equity capital is raised by selling ownership, such as selling shares in a business enterprise. 3.Public or private capital markets - Public capital markets are established by governments to provide capital in cases where a demand is not filled by the private market but is judged to have an acceptable social return. 4.Geography - Capital markets are sometimes segmented into local, regional and national markets. With the passage of rules that deregulate the industry, local markets and small banks have been integrated into the national market. B.Suppliers of capital - Suppliers of capital (savers) include households, businesses, the government, pension funds, and insurance companies. C.Demanders of capital - Demanders of capital (borrowers) include households, farmers, small and large businesses, local and national government. D.Financial intermediaries - Financial intermediaries are institutions that accumulates funds from savers and channels them to borrowers. A commercial bank is a financial intermediary. III. The Local Capital Market A.Local depository institutions - A commercial bank is a bank that takes deposits and makes loans as its primary business. Commercial banks are the most important institutions in the local capital market. They meet a full range of credit needs. Local commercial banks loan capital for: a. residential, business and agricultural real estate b. agricultural and industrial production c. consumer purchases d. state and local government expenditures