181 Financial Markets, Supply and Demand, and Interest
181 Financial Markets, Supply and Demand, and Interest
Learning Objectives
- Describe types of financial markets and how they are linked
- Explain how market forces determine interest rates in financial markets
Financial markets are made up of a large number of markets for different types of securities: equities, bonds, credit cards, etc. In the market for each asset, supply and demand interact to determine the price and rate of return. Since each financial market is both a source of borrowed funds and a destination for saving, each financial asset is a substitute for every other financial asset (to greater or lesser extent), and thus, all financial markets are linked, directly or indirectly. For example, if the interest rate on U.S. Treasury Bills goes up, you should expect the interest rates on U.S. Treasury notes and bonds to go up a certain extent also. The reason is that if interest rates on Treasury bills increase, that will make bills more attractive to people who normally invest in Treasury notes and bonds. As people shift their savings to bills, the interest rates on notes and bonds will rise.
In this section, we will explore these two features, that asset prices or rates of return are determined by supply and demand, and that all financial markets are linked. These features will help us understand later how monetary policy works.
Who Demands and Who Supplies in Financial Markets?
Financial markets can be analyzed by using the theories of supply and demand. Those who save money (or make financial investments, which is the same thing), whether individuals or businesses, are on the supply side of the financial market. Those who borrow money are on the demand side of the financial market.
In any market, the price is what suppliers receive and what demanders pay. In financial markets, those who supply financial capital through saving expect to receive a rate of return, while those who demand financial capital by receiving funds expect to pay that rate of return. A rate of return can come in a variety of forms, depending on the type of investment.
The simplest example of a rate of return is an interest rate. For example, when you put money into a savings account at a bank, you receive interest on your deposit. The interest payment expressed as a percent of your deposits is the interest rate. Similarly, if you demand a loan to buy a car or a computer, you will need to pay interest on the money you borrow.
Let’s consider the market for borrowing money with credit cards. In 2015, almost 200 million Americans were cardholders. Credit cards allow you to borrow money from the card’s issuer, and pay back the borrowed amount plus interest, although most allow you a period of time in which you can repay the loan without paying interest. A typical credit card interest rate ranges from 12% to 18% per year. In May 2016, Americans had about $943 billion outstanding in credit card debts. About half of U.S. families with credit cards report that they almost