1.2.2The supply of nancial instruments

What we have in Table 1.1 is a list of claims which are, obviously, assets to people

holding them and liabilities to those who issue them. Sometimes the issuer is an

ultimate borrower (as in the case of government stock or company shares), some-

times it is an intermediary (as in the case of building society and bank deposits).

For all of these claims there is a market. Sometimes the supply is undertaken by

a number of institutions which compete among themselves. This happens when

banks and building societies are in competition to offer deposit facilities to members

of the public. It happens, too, when a rm makes a new issue of shares. They have

to be priced and offered in such a way as to make them attractive to would-be

buyers in the light of shares being newly issued by other rms. Sometimes, however,

there is a monopoly supplier, as in the case of government stock and National

Savings certicates.

The yield that issuers of these instruments have to pay in order to make them

attractive is a cost to the issuer. Thus, other things being equal, one would expect

the supply of such claims or instruments to fall as yields rise. In Figure 1.2, there-

fore, because we have yield on the vertical axis, the supply curve slopes downwards

to the right.

1.2.3The demand for nancial instruments

As people increase their holdings of instruments, we should expect the marginal

utility attaching to each holding to diminish. Thus, as shown in section 1.1.4, there

will come a point (‘portfolio equilibrium’) when the sacrice involved in holding

any claim is just matched by the marginal utility gained from holding it. In such a

position, people will increase their holdings of an instrument only if its marginal

utility increases. Since a major component of the marginal utility of a nancial

asset is its yield, we may now say that (starting from equilibrium) there will be an

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				1.2 Financial markets

Figure 1.3(a) National Savings certicates (b) building society deposits

increased willingness to hold any kind of nancial instrument if, other things being

equal, its yield increases. The demand curve for such assets, therefore, is upward

sloping in Figure 1.2, and the market for the claim in question will be in equilibrium

at a yield of y.

1

When we talk of nancial markets (in the plural) we must be careful not to

exaggerate the degree of differentiation. While the instruments in our list above are

sometimes very different from one another, for example eurobonds and National

Savings certicates, many of the claims are very close substitutes. From this it follows

that a disturbance in one market will have a signicant effect upon several others.

Suppose that the public regards National Savings instruments as close alternatives

to building society deposits. Parts (a) and (b) of Figure 1.3 show the market for

each initially in equilibrium at a yield of y. If the government’s borrowing needs

1

then require it to issue more National Savings certicates, the supply curve in (a)

will move to S′. The yield will rise towards y. Because they are close substitutes,

2

however, this will cause a leftward shift of the demand curve in (b), as people move

out of building society deposits towards National Savings. This causes the yield on

building society deposits to rise. The transfer of buyers from one market to the other

will cease when the yields are again equalised and this, according to the gure, will

occur at y. The extent of the rise in yields depends upon the slope of the demand

2

curve in (a). This in turn depends upon the willingness of people to move out of

building society deposits, i.e. upon the substitutability of building society deposits

and National Savings certicates.