Financial markets are responsible for ensuring that the economy runs smoothly, and that investors are treated fairly. However, the role of financial markets is not limited to just that. These markets also perform other important functions, such as enhancing production and allocation efficiencies in the overall economy, and ensuring a low cost of transactions and information.
Liquidity is the ease with which a financial asset can be bought or sold. It is important for stability of the financial markets. There are several factors that affect liquidity. Some are economic and political risk, information asymmetry, and funding constraints.
The US Treasury markets are the most liquid of all markets. However, they are highly vulnerable to stress. This was shown in the COVID-19 pandemic, which affected asset-backed security markets in March of this year.
Several reasons have been proposed for why market liquidity evaporated during the stress. One reason is a failure of the banking system to create sufficient liquidity. Another factor is the regulatory environment. Banks are required to hold reserves against liquid assets, and this constrains their ability to offer liquidity.
Regulatory changes made by the Federal Reserve and the banking sector may have contributed to the decline in market liquidity. Additionally, increased political uncertainty has caused pessimism among investors. A reduction in trading activity, which results in lower prices, also has an impact on liquidity.
Enhance production and allocation efficiencies in the overall economy
Allocating resources efficiently is a key aspect of a successful economy. It allows an economy to produce more of a product without affecting other production processes. In other words, efficient economies allocate scarce resources to achieve optimum benefits and minimize costs.
The best resource allocation is determined by the consumer demand. For example, young consumers prefer education over health care. However, older populations need more health care. Hence, a society that produces a large amount of education is achieving allocative efficiency.
Similarly, the optimal production and allocation efficiencies of an overall economy are determined by the supply and demand curves of the products and services produced. If a particular good is in short supply, the price of the product will be higher. This will reduce the demand for the product.
Allocative efficiency occurs when a product is produced to meet the demand of the consumer at the marginal cost. In other words, the marginal benefit of producing an additional unit of a good is equal to the marginal cost of producing the same quantity.