1.2.4Stocks and ows in nancial markets

In sections 1.2.2 and 1.2.3 we saw how the basic ideas of supply and demand could

be applied to the market for those kinds of nancial instruments, like building

society deposits, which are not traded between third parties.

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Chapter 1 • Introduction: the nancial system

Our analysis proceeded exactly as it would do for any other good or service with

one exception: the demand and supply curves had the opposite of their normal

slope. We must be careful not to exaggerate the importance of this. It arose only

because we had ‘yield’ on the vertical axis where normally we would have ‘price’. In

fact, even this is not a very signicant difference from the usual case. We have

already mentioned xed-interest bonds. In Chapter 6 we shall see that the price of

any instrument whose rate of interest is xed at the time of issue must vary inversely

with movements in market interest rates. Thus we could analyse our markets for

building society deposits and National Savings certicates as if these instruments

bore a xed rate of interest but uctuated in price. It would not seem very realistic

but it would be analytically quite correct. Then we could have price on the vertical

axis and the curves would have their normal slopes. The supply curve for such

instruments would slope upwards, showing that as the price rose (and yield fell),

ultimate borrowers or intermediaries would be willing to issue more; the demand

curve would slope downwards, showing that as the price fell (and yield rose), lenders

would be willing to buy more of such instruments.

Let us repeat: the unusual slope of the curves in Figures 1.2 and 1.3 is not important.

What is much more important is the fact that the supply curve has any slope at

all. What the slope tells us is that more of the instrument in question will be

supplied the higher its price (or the lower its yield). This is what one would expect

for most goods and services. It is not, however, typical for all nancial instruments.

The cases we were looking at above involved ‘non-securitised instruments’. This

means that the supplier of the instrument, the person or rm offering it ‘for sale’,

is also the creator of that instrument. Again, this is what is normally envisaged in

market analysis. As the price of a good rises, a prot-maximising rm increases its

production so as to equate marginal cost with the (now) higher marginal revenue

or price. The increase in price calls forth a ow of additional output. This is what

happens when the demand for building society deposits increases. Funds ow into

the societies, which happily create new deposits, lowering the rate of interest on

those deposits if the inow is sufciently large. A sufciently large outow of deposits,

on the other hand, will require building societies to raise the yield on deposits, as in

Figure 1.3(b).

However, in the markets for securities, where nancial instruments are traded

between third parties, the buyer is rarely buying from the producer of the good.

Take, for example, the case of ordinary company shares. A decision to buy shares is

not normally a decision to buy new shares from the company that issued them. It

is a decision to buy shares from someone who currently holds some of the existing

stock of shares and it does nothing to increase their supply. Equally, a generalised

increase in demand for ICI shares does nothing directly to increase the supply of

ICI shares. It indicates an increased desire on the part of the share-owning public

to hold the existing stock of shares. Nothing in the immediate future is going to

happen to increase the quantity of ICI shares in existence. All that can happen is

that this increase in demand causes a rise in price. In terms of supply and demand

analysis, whether we have yield or price on the vertical axis, the supply curve will

be vertical.

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