Chapter

4 Efficiency and Stability

Author(s):
Garry Schinasi
Published Date:
December 2005
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This chapter distinguishes briefly between the concepts of efficiency and stability. It then discusses three situations that help put observed financial dynamics into perspective.

Economic, or Financial, Efficiency

What is meant by efficiency, in more rigorous terms than were used in Chapter 3? Take a simple example of a market for a financial instrument—credit, for instance. The market demand for credit can be represented by a demand schedule that plots the various combinations of the cost of a unit of credit against the aggregate demand for credit forthcoming for each unit cost. Under normal conditions, the demand curve would be downward sloping indicating that as cost per unit of credit declines, more and more individuals want to borrow, and some want to borrow more units as the cost per unit declines. One can also envision a market supply curve that plots the combinations of cost and aggregate supply of credit. Under normal conditions this supply curve would be upward sloping indicating that as the cost of a unit of credit rises it becomes more profitable to supply, so a greater aggregate supply is forthcoming. Market equilibrium occurs at the price and quantity pair for which demand equals supply. This concept can be expanded to cover many markets simultaneously, including for goods and services as well as other asset prices.

When considering efficiency, the key issue is whether the aggregate demand and supply curves represent private benefits and costs or social benefits and costs or both simultaneously. If the curves represent both simultaneously, the equilibrium is efficient—both the price and quantity of credit match the private and social price of credit and the socially desirable quantity of credit. This is illustrated in Figure 4.1, in which schedule DD is the demand curve representing both the private and social benefits that would be obtained per unit of credit for each aggregate quantity or amount of credit demanded. Likewise, schedule SS is the supply curve with the cost per unit of credit representing both the private and social costs of producing the aggregate quantity or amount of credit.

Figure 4.1.Private Demand and Supply Equal to Social Demand and Supply

Note: PS and QS represent social price and quantity, respectively. PP and QP represent private price and quantity, respectively. P* and Q* represent equilibrium price and quantity, respectively.

Now consider a situation, depicted in Figure 4.2, in which the private market demand—the dotted demand schedule—lies below the social demand curve. The fact that the private demand curve lies below the social demand curve means that for each quantity demanded the private benefit is less then the social benefit. This occurs because individual private demanders only consider their personal benefit and not the potential benefits to others not consuming the good directly. In this case, the unfettered market outcome would lead to a quantity of credit QP that falls short of the socially desirable amount of credit QS. In addition, the price paid per unit of credit would be PP, which is below the price that would be paid along the demand curve that represents social benefits or PS.

Figure 4.2.Private Marginal Benefit Below Social Marginal Benefit

Note: PS and QS represent social price and quantity, respectively. PP and QP represent private price and quantity, respectively.

Figure 4.3 illustrates an example in which the market supply curve is below society’s supply curve meaning that for each aggregate quantity supplied, the market is only considering the lower private cost of a unit of credit and not the social cost (for example, the additional social cost of the pollution created in the production process). This means that private outcomes would result in a quantity of credit in excess of the socially desirable amount, reflecting the underpricing of a unit of credit risk—at PP < PS.

Figure 4.3.Private Marginal Cost Below Social Marginal Cost

Note: PS and QS represent social price and quantity, respectively. PP and QP represent private price and quantity, respectively.

Stability

Under normal conditions—with the demand curve downward sloping, the supply curve upward sloping, and excess demand implying a price increase—the market-clearing (equilibrium) price and quantity of credit would be stable. Here stability is defined as the following situation: if at any given price (such as at P1 in Figure 4.4) the quantity demanded exceeds supply, the price and quantity supplied would rise back toward the market equilibrium—for example, along the supply curve in Figure 4.4. Symmetrically, if at some given price (say P2) demand falls short of supply, the price would decline and the quantity demanded would rise along the demand schedule. This is what is typically meant by stability in economics—a tendency for price and supply to rise when demand exceeds supply; and a tendency for price to fall and demand to rise when supply exceeds demand. This concept of stability can be extended to deal with a set of markets, and is an application of the stability analysis often applied in Newtonian physics and other sciences.

Figure 4.4.Stable Disequilibrium

Note: P* and Q* together represent a “Stable Disequilibrium” when either P* is not equal to the socially optimal price or Q* is not equal to the socially optimal quantity or both.

In the example used above, the demand and supply curves are linear, so the dynamics are uncomplicated. With nonlinear demand and supply curves, or by specifying more complicated and multidimensional demand and supply processes, the dynamics can become quite complex. An extensive discussion of these complexities is beyond the scope of this book, but such complexities obviously exist in the real world, particularly in financial systems and in financial-stability analysis. Some of these complexities and their implications for financial-stability assessments will be discussed briefly in Chapter 6, where measurement and modeling issues are examined.

Considering Efficiency and Stability

Three situations illustrate efficiency and stability in financial markets.

The first situation to consider is that of perpetual stability and efficiency, where the social equilibrium and private equilibrium are identical and stable. In such a situation, the equilibrium price reflects both the private and social costs and benefits, and the market is stable in the sense that if price deviates from the equilibrium for some unforeseen reason, prices and quantities will tend to gravitate back to the social equilibrium.

A second situation is one of perpetual stability with inefficiency. In this case, the market finds an equilibrium at the intersection of private demand and supply, which is stable. Although a social equilibrium exists, it would be unstable and therefore unsustainable, which implies that while a socially optimal outcome in the financial system exists, it cannot be maintained because it is unstable. Thus, in this second instance, while the financial system can remain in equilibrium—that is, stable—it is also inefficient.

A third situation is one of intermittent instability with inefficiency. Both private and social equilibria exist, but both are unstable and therefore unsustainable. Unless the financial system starts off in equilibrium and remains undisturbed, the financial system will tend to wander in ways that are determined by its internal structure and the external forces that impinge on it.

The real world is probably most accurately characterized as lying somewhere between the second and third situations. This is consistent with what has been observed in the international financial system (see Table 1.6), which recently experienced periods of stability with intermittent periods of

  • high volatility and market turbulence, as experienced during the bond-market turbulence of 1994 and again in 1996;
  • persistent asset-price misalignments, as experienced in the behavior of the dollar-yen exchange rate in the mid-1990s, and the dollar-euro rate in 2002–2004;
  • asset-price bubbles, as experienced during the build-up and then bursting of the dot-com bubble in 1999–2000;
  • financial fragility, as experienced in Russia during the aftermath of the Russian debt default and in global markets during the near collapse of the hedge fund Long-Term Capital Management;
  • financial crises, as experienced in Asia in 1997–98 and in some Latin American economies in the early 2000s.42
42See Davis (2002) for a useful classification of deviations from stability and a more thorough examination of recent periods of such deviations. Also see various issues of the IMF’s International Capital Markets: Developments, Prospects, and Key Issues for the years 1993–2001 for descriptions and analyses of many of these episodes.

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