Question

Question 4.4

1. Give two examples of financial markets.
2. Identify the demanders and suppliers in a financial market.
3. Explain why interest rates are the price of lending or borrowing loanable funds. Show the equilibrium interest rate (r*) on a graph.
4. Explain what usury laws are, articulating who wins and who loses when a cap is placed on the amount of interest that could be charged in the financial markets. Graph this effect.

Answer 1

Financial market is a place where buyers and sellers meet to exchange goods or services at prices predetermined by demand and supply.

Examples of financial market

1 stock market like New York stock exchange is an example of physical and digital financial market. Here financing is provided through the buying and selling of stock

2 Bond market is a financial market where finance is provided through buying selling and issuing bonds. This market is generally considered a capital market because it provides financing for long term investments.

2. The key suppliers and demanders of funds are individuals, businesses and government

Where individuals are net suppliers while businesses and government are net demanders.

3. Interest is the price paid for use of money. In a loanable funds (amount of money available for borrowing) market borrowers exchange the ability to purchase today in exchange for ability to purchase in future where interest is stated as the percentage of amount borrowed.

4 usury laws are regulations which govern the amount of interest that can be charged on a loan. They specifically target the practice of charging excessively high rates on loans by setting caps. The main purpose is to protect the consumer.

The firms which impose high interest rate respond that higher rates are necessary to cover for losses created by those who use the service but do not pay for example a credit card user.  

Consider the above figure depicting credit card market where a law imposes price ceiling that sets the interest rate charged on credit card at R1. Here the demand and supply model suggests that at lower price ceiling interest rate the qty demanded of credit card debt will increase from Q0 to Qd however the qty supplied will decrease from Q0 to Qs. It means there will be shortage of credit

Another point of view in the same figure can be that the price ceiling at R1 is below the equilibrium interest rate so the interest rate cannot adjust upwards to the equilibrium where again Qd exceeds Qs showing excess demand or shortage.

In another case where price ceiling if set at a relatively high level will be nonbinding because it will not have any practical advantage unless equilibrium price rises high above to exceed the price ceiling.