THE FINANCIAL MARKET ECONOMY
Financial markets develop to facilitate borrowing and lending between individuals. Here we talk about how this happens. Suppose we describe the economic circumstances of two people, Tom and Leslie. Both Tom and Leslie have current income of $100,000. Tom is a very patient person, and some people call him a miser. He wants to consume only $50,000 of current income and save the rest. Leslie is a very impatient person, and some people call her extravagant. She wants to consume $150,000 this year. Tom and Leslie have different
intertemporal consumption preferences.
Such preferences are personal matters and have more to do with psychology than with finance. However, it seems that Tom and Leslie could strike a deal: Tom could give up some of his income this year in exchange for future income that Leslie can promise to give him.
Tom can lend $50,000 to Leslie, and Leslie can borrow $50,000 from Tom.
Suppose that they do strike this deal, with Tom giving up $50,000 this year in exchange for $55,000 next year. This is illustrated in Figure 3.1 with the basic cash flow time chart, a representation of the timing and amount of the cash flows. The cash flows that are received are represented by an arrow pointing up from the point on the time line at which the cash flow occurs. The cash flows paid out are represented by an arrow pointing down. In other words, for each dollar Tom trades away or lends, he gets a commitment to get it back as
well as to receive 10 percent more. In the language of finance, 10 percent is the annual rate of interest on the loan. When a dollar is lent out, the repayment of $1.10 can be thought of as being made up of two parts.
First, the lender gets the dollar back; that is the principal repayment. Second, the lender receives an interest payment, which is $0.10 in this example.
Now, not only have Tom and Leslie struck a deal, but as a by-product of their bargain they have created a financial instrument, the IOU. This piece of paper entitles whoever receives it to present it to Leslie in the next year and redeem it for $55,000. Financial instruments that entitle whoever possesses them to receive payment are called bearer instruments because whoever bears them can use them. Presumably there could be more such IOUs in the economy written by many different lenders and borrowers like Tom and Leslie.
The Anonymous Market
If the borrower does not care whom he has to pay back, and if the lender does not care whose IOUs he is holding, we could just as well drop Tom’s and Leslie’s names from their contract. All we need is a record book, in which we could record the fact that Tom has lent $50,000 and Leslie has borrowed $50,000 and that the terms of the loan, the interest rate, are 10 percent. Perhaps another person could keep the records for borrowers and lenders, for a fee, of course. In fact, and this is one of the virtues of such an arrangement, Tom and Leslie wouldn’t even need to meet. Instead of needing to find and trade with each other, they could each trade with the record keeper. The record keeper could deal with thousands of such borrowers and lenders, none of whom would need to meet the other.
Institutions that perform this sort of market function, matching borrowers and lenders or traders, are called financial intermediaries. Stockbrokers and banks are examples of financial intermediaries in our modern world. A bank’s depositors lend the bank money, and the bank makes loans from the funds it has on deposit. In essence, the bank is an intermediary between the depositors and the ultimate borrowers. To make the market work, we must be certain that the market clears. By market clearing we mean that the total amount that people like Tom wish to lend to the market should equal the total amount that people
like Leslie wish to borrow.
Market Clearing
If the lenders wish to lend more than the borrowers want to borrow, then presumably the interest rate is too high. Because there would not be enough borrowing for all of the lenders at, say, 15 percent, there are really only two ways that the market could be made to clear. One is to ration the lenders. For example, if the lenders wish to lend $20 million when interest rates are at 15 percent and the borrowers wish to borrow only $8 million, the market could
take, say, 8/20 of each dollar, or $0.40, from each of the lenders and distribute it to the borrowers. This is one possible scheme for making the market clear, but it is not one that would be sustainable in a free and competitive marketplace. Why not?
To answer this important question, let’s go back to our lender, Tom. Tom sees that interest rates are 15 percent and, not surprisingly, rather than simply lending the $50,000 that he was willing to lend when rates were 10 percent, Tom decides that at the higher rates he would like to lend more, say $80,000. But since the lenders want to lend more money than the borrowers want to borrow, the record keepers tell Tom that they won’t be able to take all of his $80,000; rather, they will take only 40 percent of it, or $32,000. With the interest
rate at 15 percent, people are not willing to borrow enough to match up with all of the loans that are available at that rate.
Tom is not very pleased with that state of affairs, but he can do something to improve his situation. Suppose that he knows that Leslie is borrowing $20,000 in the market at the 15 percent interest rate. That means that Leslie must repay $20,000 on her loan next year plus the interest of 15 percent of $20,000 or 0.15 ϫ $20,000 ϭ $3,000. Suppose that Tom goes to Leslie and offers to lend her the $20,000 for 14 percent. Leslie is happy because she will save 1 percent on the deal and will need to pay back only $2,800 in interest next year. This is $200 less than if she had borrowed from the record keepers. Tom is happy too, because he
has found a way to lend some of the money that the record keepers would not take. The net result of this transaction is that the record keepers have lost Leslie as a customer. Why should she borrow from them when Tom will lend her the money at a lower interest rate?
Tom and Leslie are not the only ones cutting side deals in the marketplace, and it is clear that the record keepers will not be able to maintain the 15 percent rate. The interest rate must fall if they are to stay in business.
Suppose, then, that the market clears at the rate of 10 percent. At this rate the amount of money that the lenders wish to lend is exactly equal to the amount that the borrowers desire. We refer to the interest rate that clears the market, 10 percent in our example, as the equilibrium rate of interest.
In this section we have shown that in the market for loans, bonds or IOUs are traded. These are financial instruments. The interest rate on these loans is set so that the total demand for such loans by borrowers equals the total supply of loans by lenders. At a higher interest rate, lenders wish to supply more loans than are demanded, and if the interest rate is lower than this equilibrium level, borrowers demand more loans than lenders are willing to supply.
Financial markets develop to facilitate borrowing and lending between individuals. Here we talk about how this happens. Suppose we describe the economic circumstances of two people, Tom and Leslie. Both Tom and Leslie have current income of $100,000. Tom is a very patient person, and some people call him a miser. He wants to consume only $50,000 of current income and save the rest. Leslie is a very impatient person, and some people call her extravagant. She wants to consume $150,000 this year. Tom and Leslie have different
intertemporal consumption preferences.
Such preferences are personal matters and have more to do with psychology than with finance. However, it seems that Tom and Leslie could strike a deal: Tom could give up some of his income this year in exchange for future income that Leslie can promise to give him.
Tom can lend $50,000 to Leslie, and Leslie can borrow $50,000 from Tom.
Suppose that they do strike this deal, with Tom giving up $50,000 this year in exchange for $55,000 next year. This is illustrated in Figure 3.1 with the basic cash flow time chart, a representation of the timing and amount of the cash flows. The cash flows that are received are represented by an arrow pointing up from the point on the time line at which the cash flow occurs. The cash flows paid out are represented by an arrow pointing down. In other words, for each dollar Tom trades away or lends, he gets a commitment to get it back as
well as to receive 10 percent more. In the language of finance, 10 percent is the annual rate of interest on the loan. When a dollar is lent out, the repayment of $1.10 can be thought of as being made up of two parts.
First, the lender gets the dollar back; that is the principal repayment. Second, the lender receives an interest payment, which is $0.10 in this example.
Now, not only have Tom and Leslie struck a deal, but as a by-product of their bargain they have created a financial instrument, the IOU. This piece of paper entitles whoever receives it to present it to Leslie in the next year and redeem it for $55,000. Financial instruments that entitle whoever possesses them to receive payment are called bearer instruments because whoever bears them can use them. Presumably there could be more such IOUs in the economy written by many different lenders and borrowers like Tom and Leslie.
The Anonymous Market
If the borrower does not care whom he has to pay back, and if the lender does not care whose IOUs he is holding, we could just as well drop Tom’s and Leslie’s names from their contract. All we need is a record book, in which we could record the fact that Tom has lent $50,000 and Leslie has borrowed $50,000 and that the terms of the loan, the interest rate, are 10 percent. Perhaps another person could keep the records for borrowers and lenders, for a fee, of course. In fact, and this is one of the virtues of such an arrangement, Tom and Leslie wouldn’t even need to meet. Instead of needing to find and trade with each other, they could each trade with the record keeper. The record keeper could deal with thousands of such borrowers and lenders, none of whom would need to meet the other.
Institutions that perform this sort of market function, matching borrowers and lenders or traders, are called financial intermediaries. Stockbrokers and banks are examples of financial intermediaries in our modern world. A bank’s depositors lend the bank money, and the bank makes loans from the funds it has on deposit. In essence, the bank is an intermediary between the depositors and the ultimate borrowers. To make the market work, we must be certain that the market clears. By market clearing we mean that the total amount that people like Tom wish to lend to the market should equal the total amount that people
like Leslie wish to borrow.
Market Clearing
If the lenders wish to lend more than the borrowers want to borrow, then presumably the interest rate is too high. Because there would not be enough borrowing for all of the lenders at, say, 15 percent, there are really only two ways that the market could be made to clear. One is to ration the lenders. For example, if the lenders wish to lend $20 million when interest rates are at 15 percent and the borrowers wish to borrow only $8 million, the market could
take, say, 8/20 of each dollar, or $0.40, from each of the lenders and distribute it to the borrowers. This is one possible scheme for making the market clear, but it is not one that would be sustainable in a free and competitive marketplace. Why not?
To answer this important question, let’s go back to our lender, Tom. Tom sees that interest rates are 15 percent and, not surprisingly, rather than simply lending the $50,000 that he was willing to lend when rates were 10 percent, Tom decides that at the higher rates he would like to lend more, say $80,000. But since the lenders want to lend more money than the borrowers want to borrow, the record keepers tell Tom that they won’t be able to take all of his $80,000; rather, they will take only 40 percent of it, or $32,000. With the interest
rate at 15 percent, people are not willing to borrow enough to match up with all of the loans that are available at that rate.
Tom is not very pleased with that state of affairs, but he can do something to improve his situation. Suppose that he knows that Leslie is borrowing $20,000 in the market at the 15 percent interest rate. That means that Leslie must repay $20,000 on her loan next year plus the interest of 15 percent of $20,000 or 0.15 ϫ $20,000 ϭ $3,000. Suppose that Tom goes to Leslie and offers to lend her the $20,000 for 14 percent. Leslie is happy because she will save 1 percent on the deal and will need to pay back only $2,800 in interest next year. This is $200 less than if she had borrowed from the record keepers. Tom is happy too, because he
has found a way to lend some of the money that the record keepers would not take. The net result of this transaction is that the record keepers have lost Leslie as a customer. Why should she borrow from them when Tom will lend her the money at a lower interest rate?
Tom and Leslie are not the only ones cutting side deals in the marketplace, and it is clear that the record keepers will not be able to maintain the 15 percent rate. The interest rate must fall if they are to stay in business.
Suppose, then, that the market clears at the rate of 10 percent. At this rate the amount of money that the lenders wish to lend is exactly equal to the amount that the borrowers desire. We refer to the interest rate that clears the market, 10 percent in our example, as the equilibrium rate of interest.
In this section we have shown that in the market for loans, bonds or IOUs are traded. These are financial instruments. The interest rate on these loans is set so that the total demand for such loans by borrowers equals the total supply of loans by lenders. At a higher interest rate, lenders wish to supply more loans than are demanded, and if the interest rate is lower than this equilibrium level, borrowers demand more loans than lenders are willing to supply.
Комментариев нет:
Отправить комментарий