Equilibrium in financial markets:
Equilibrium in financial markets is usually determined by the assuming that there would be perfect competition, and by using the well-known tools of demand and supply.
Equilibrium in financial markets is established when the expected demand for funds(credit) for short-term and long-term investments matches with the planned supply of funds generated out of saving and credit-creation. In other words, the equality of total desired borrowing with the total desired lending is necessary for establishing equilibrium rate of interest.
Any increase or decrease in either demand or supply of funds will disturb the equilibrium and a new equilibrium will come to be established. The supply of funds comes from the aggregate savings of the household sector, business sector and the government sector. Saving equals the difference between the disposable income and the consumption expenditure in a given year, i.e.,
S = Yd -C
A number of factors influence the volume of savings in the economy like the level of current and expected income, cyclical changes in income, age-wise variations in income, distribution of income in the economy, degree of certainty of income, wealth, inflation, desire to provide for old age, contingencies, thrift, rate of interest and availability of saving media with preferred investment characteristics, etc. Another major determinant of supply of funds is the development of banks and other financial institutions, which, in turn determine the credit multiplier.