In the previous note on the lecture series of financial institutions and markets, we learned about the financial system. It is classified into two major classes: financial institutions and financial markets. In this note, we will learn about the equilibrium in the financial market based on the demand and supply of funds. Equilibrium in the financial market is a interest rate which should be fair for both the parties. Let us understand with an example.
Suppose the market is not in equilibrium, which means whatever pricing for any security we are seeing is not the actual reflection based on the demand and supply. There are always two parties, and one plays a supplier role, and another plays a request or needy role. Moreover, after a special deal, both the parties should feel that the agreement was fair. Let us understand what market equilibrium is and what are the equilibrium assumptions.
Market Equilibrium – Supply & Demand
Equilibrium is established when the expected demand for funds (credit) for short-term & long-term investment matches with the planned supply of funds generated out of savings and credit creation. The two main players are:
- The investors demand for funds
- The savers supply funds
If these is an equality between these two then we can say that the market is in the equilibrium. Moreover, it means, that both the parties are getting fair price. However, the equilibrium in financial markets is usually determined by assuming that there would be perfect competition, and by using the well-known tool of supply and demand. The assumption of perfect financial market is very important and these assumptions are as follows for the market equilibrium.
- There should be a large number of savers and investors operating in markets. Otherwise, savers or investors can collude and divert the market towards their side.
- The savers and investors have rational thinking. It means all are intelligent and invest money for good returns.
- All operators in the market are well-informed, and information is freely available to all of them. It means, suppose someone wants to invest in a particular stock, they should be able to freely, openly, and uniformly assess the company’s financial information. There should not be any kind of discrepancy irrespective of the investors or market participants.
- There should not be any transactions costs. It is a bit impractical assumption, as there is always an operating cost when things are managed via the centralized system or by the organization.
- The financial assets are infinitely divisible. It means there should not be any time limit. For example, once someone has purchased a particular stock. They should be able to sell/buy at the next moment.
- The participants in markets have homogeneous expectations. However, the homogeneous expectation is a subjective belief and for the ideal situation, we consider that all investors have the exact expectations and may arrive at similar conclusions.
Understanding of Demand and Supply
- The (SS) curve shows the aggregate supply of funds and (DD) curve shows the aggregate demand for funds. Their intersection point E, reflects the equilibrium position at which Q amount of funds will be supplied and demanded at the equilibrium rate of interest, r.
- The supply curve slopes upward from left to right, which means that as the rate of interest increases, more funds would be made available in the financial system. For example, from the supply point of view, if the bank starts paying more interest rate than people would prefer to keep money in their bank account.
- The demand curve slopes downward from left to right, which means that as the rate of interest increases, the demand for finance would decline. For example, from the demand point of view, if the interest rate is higher, very few people (home loan), organizations (business loan for extension of business), Investors, etc., will take the loan and as a consequence demand decreases.
Determinants of Supply of Funds
The most important factor which affect the supply of the fund is the aggregate savings of household sector, business sector and the government sector. However, major contributor for the supply of the fund comes from household sector. So if there is some changes in the supply side the behaviour of the consumer changes and depositor changes. Thus, supply of the funds to the market will be changed in accordance with in the changing behavoir of the depositors or the market participants. The reasons for the saving behavior change is due to the change in the income.
Determinants of Demand of Funds
The financial markets are characterised by many imperfections, restrictive practices, and externalities. The existince of transactions costs, lack of information, limited number of operators, direct and indirect intervention by the authorities.
- The investment in fixed and circulating or working capital. The desired capital stock, which is influenced by business expectations regarding future demand for goods, prices, government policies, and profitability.
- Demand for consumer durables, it is like demand for consumer durables depends upon, changes in tastes and preferences, fashion, demonstration effect, and cost of funds.
- Investment in housing
The financial markets are characterised by many imperfections, restrictive practices, and externalities. The existence of transactions costs, lack of information, limited number of operators, direct and indirect intervention by the authorities.
References
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“Equilibrium in financial market” From NotePub.io – Publish & Share Note! https://notepub.io/notes/finance/financial-institutions-and-markets/equilibrium-is-financial-markets/
