Final answer:
Borrowing and lending at the risk-free rate relate to the position of investors on the efficient frontier, where risk and return are optimized. Changes in risk perception or return can shift investor preferences, impacting financial capital supply and demand curves similarly to the credit card market interest rate example.
Step-by-step explanation:
The relationship between borrowing and lending at the risk-free rate and the efficient frontier involves understanding how investors deal with the trade-off between rate of return and risk. The efficient frontier represents portfolios that offer the highest expected return for a given level of risk. Investors can lend at the risk-free rate if they are averse to risk, which typically has a lower return but also lower risk. Conversely, they can borrow at the risk-free rate to invest in portfolios on the efficient frontier, enhancing potential returns but also increasing risk. When investors shift their funds from a riskier investment (with diminishing returns) to a safer one, this affects the supply and demand curves in the financial market.
As depicted in figure 4.5, supply and demand for borrowing are demonstrated through the credit card market example, where the demand curve intersects the supply curve at equilibrium. This equilibrium is affected by changes in interest rates. If interest rates are above equilibrium, the quantity of financial capital supplied increases, but demand decreases. Below equilibrium, the situation reverses. These mechanisms also apply broadly to investments as investors seek to maximize returns for their accepted level of risk.