A market is a place where buyers and sellers meet. It can be a physical building or an electronic network. It can be local, national, or international. Markets are often categorized according to the products or services in which they deal. For example, there are labor markets, consumer goods markets, and financial markets.
At the heart of each transaction in these markets are two elements: a selling side and a buying side. In economic terms, the selling side is often referred to as the supply side, while the buying side is called the demand side.
The forces of supply and demand in a particular market determine the price at which goods and services will change hands. Just about any situation in economics can be explained in terms of supply and demand.
A financial market is a market in which financial assets are traded. In financial markets, there are suppliers of capital and consumers of capital. Just as in other markets financial market prices reflect supply and demand.
The supply of capital in the Canadian financial markets comes from the following sources:
- household savings
- retained earnings that corporations have not paid out as dividends
- budget surpluses in the government sector
- savings from abroad
These sources of supply, commonly referred to as lenders, are willing to lend out capital to some entity with the expectation of profit in return.
The demand for investment capital comes from the spending decisions of the following:
- governments (federal, provincial, municipal)
- Canadian households
- and foreigners interested in the Canadian financial markets
These consumers of capital are commonly referred to as borrowers.
For example, if a government needs to borrow funds it issues bonds. Investors purchase those bonds and act as lenders to the government.
Financial markets are subject to the same supply and demand influences as any other market and can be viewed in the same manner. If there is a sudden increase in demand for stocks or bonds, then the cost of those investments rises as the demand curve shifts upwards.
Importance of Financial Markets
Being able to convert idle savings into investment capital is critical for the long-term prosperity of an economy. For example, by lending money to buy new housing, banks help local infrastructures grow and meet the needs of an expanding population. The same is true when governments borrow money to build hospitals and roads or when corporations issue securities to finance the expansion of their operations. Without access to investment capital, governments and companies are limited by the amount of capital they can access internally.
Nations with low levels of savings tend to have low rates of investment and low rates of economic growth. Nations with healthy economic growth tend to have well-developed financial markets that encourage saving and investing.
Financial markets serve borrowers and lenders in three ways:
• channeling funds from lenders to borrowers
• facilitating the timing of purchases
• providing a mechanism for government policy
1. Channelling Funds
The movement of investment capital from the suppliers to those with demand may be done directly but is usually handled indirectly by intermediaries such as banks, trust companies, and investment dealers.
In the case of direct financing, a borrower deals directly with the lender. For example, if a person needs to borrow $1,000 he or she might approach friends and family members to find someone with $1,000 to lend. This is not efficient.
In the case of indirect financing, a borrower does not deal directly with the person who has money to lend. Instead, he or she approaches a financial intermediary who acts as a middleman, bringing many borrowers and lenders together. The most common financial intermediaries are banks. Banks have a large pool of funds from their many depositors (lenders) that they can make available to borrowers.
2. Facilitating Timing of Purchases
Financial markets enable people to time their spending and saving to fit their lifestyle and circumstances. Through financial markets, households have the opportunity to spend some years and save on others. For instance, in their younger years, people set aside savings and invest part of their income while they are working. Later in life when they reach retirement, they begin to draw down from their savings and investments to help finance retirement expenses. Financial markets help facilitate the timing of when they want to save or invest and when they want to withdraw and spend.
3. Providing a Mechanism for Government Policy
Financial markets can be used as a mechanism to facilitate Federal government policy.
For instance, one of the key monetary policies in Canada is inflation control. The Federal government and the Bank of Canada work together to set targets for the country’s inflation rate.
If the Canadian economy is perceived to be growing too quickly, it can be interpreted as a sign of inflationary pressure. The Bank of Canada can increase its overnight interest rate.
Financial markets then transmit these changes to the rest of the economy. This rise in the overnight interest rate will result in a rise in longer-term interest rates in Canada. As a consequence, the cost of borrowing increases making it more expensive for borrowers like consumers looking to purchase homes or corporations wanting to invest in new equipment to access capital. In turn, this causes the economy to slow down and eventually eases the inflationary pressure which was the original concern of the Bank of Canada.
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