Asset markets allow people to change their pattern of consumption over time. Consider, for example, two people A and B who have different endowments of wealth. A might have $100 today and nothing tomorrow, while B might have $100 tomorrow and nothing today. It might well happen that each would rather have $50 today and $50 tomorrow. But they can reach this pattern of consumption simply by trading: A gives B $50 today, and B gives A $50 tomorrow.
In this particular case, the interest rate is zero: A lends B $50 and only gets $50 in return the next day. If people have convex preferences over consumption today and tomorrow, they would like to smooth their consumption over time, rather than consume everything in one period, even if the interest rate were zero.
We can repeat the same kind of story for other patterns of asset endowments. One individual might have an endowment that provides a steady stream of payments and prefer to have a lump sum, while another might have a lump sum and prefer a steady stream. For example, a twenty-year-old individual might want to have a lump sum of money now to buy a house, while a sixty-year-old might want to have a steady stream of money to finance his retirement. It is clear that both of these individuals could gain by trading their endowments with each other.
In a modern economy financial institutions exist to facilitate these trades. In the case described above, the sixty-year-old can put his lump sum of money in the bank, and the bank can then lend it to the twenty-year-old.
1 See Louis Uchitelle, "Russians Line Up for Gas as Refineries Sit on Cheap Oil," New
York Times, July 12, 1992, page 4.
The twenty-year-old then makes mortgage payments to the bank, which are, in turn, transferred to the sixty-year-old as interest payments. Of course, the bank takes its cut for arranging the trade, but if the banking industry is sufficiently competitive, this cut should end up pretty close to the actual costs of doing business.
Banks aren't the only kind of financial institution that allow one to reallocate consumption over time. Another important example is the stock market. Suppose that an entrepreneur starts a company that becomes successful. In order to start the company, the entrepreneur probably had some financial backers who put up money to help him get started—to pay the bills until the revenues started rolling in. Once the company has been established, the owners of the company have a claim to the profits that the company will generate in the future: they have a claim to a stream of payments.
But it may well be that they prefer a lump-sum reward for their efforts now. In this case, the owners can decide to sell the firm to other people via the stock market. They issue shares in the company that entitle the shareholders to a cut of the future profits of the firm in exchange for a lump-sum payment now. People who want to purchase part of the stream of profits of the firm pay the original owners for these shares. In this way, both sides of the market can reallocate their wealth over time.
There are a variety of other institutions and markets that help facilitate intertemporal trade. But what happens when the buyers and sellers aren't evenly matched? What happens if more people want to sell consumption tomorrow than want to buy it? Just as in any market, if the supply of something exceeds the demand, the price will fall. In this case, the price of consumption tomorrow will fall. We saw earlier that the price of consumption tomorrow was given by
so this means that the interest rate must rise. The increase in the interest rate induces people to save more and to demand less consumption now, and thus tends to equate demand and supply.
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