Efficiency on the dynamic adjustment path in a financial market
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Efficiency on the dynamic adjustment path in a financial market Nasreen Nawaz 1 # Academy of Economics and Finance 2020
Abstract The invisible hand of a perfectly competitive financial market refers to the self-regulating behavior of the market where if each consumer and producer of funds is allowed to freely make their own choices, the market settles at an efficient outcome which is beneficial to all the individual members of the society and hence to the society as a whole. Two wellknown facets of the invisible hand are generally mentioned in the economics and finance literature - the first one is a static picture of a perfectly competitive market, i.e., a competitive market is efficient in an equilibrium; and the second one is that if the competitive market is disturbed from its equilibrium position, in the absence of a market failure and frictions, the market automatically settles at a new efficient equilibrium. This paper takes into account a third facet, i.e., how efficient is a perfectly competitive financial market on the dynamic adjustment path after an economic shock in the absence of all kinds of frictions and interest rate rigidities. We conclude that coordinated actions of economic agents can result in a level of economic efficiency on the dynamic adjustment path which is not achievable by a free market mechanism. Keywords Dynamic efficiency . Adjustment path . Equilibrium . Coordination JEL Classification D40 . D41 . D50 . E32 . G10 . G18 . G28
1 Introduction Adam Smith’s invisible hand was a clever mechanism for describing how information, idiosyncratic and dispersed among individuals, is accumulated and combined by the market mechanism such that the overall market equilibrium is the same as that would Electronic supplementary material The online version of this article (https://doi.org/10.1007/s12197-02009523-7) contains supplementary material, which is available to authorized users.
* Nasreen Nawaz [email protected]
1
Federal Board of Revenue, Lahore, Pakistan
Journal of Economics and Finance
be obtained by an all-knowing social planner. This result is the core principle of all modern Samuelsonion welfare economics. However, the existing literature inadequately addresses the efficiency issue on the dynamic adjustment path of the market after an economic shock before it arrives at a new efficient equilibrium, and rather an adjustment mechanism has never been defined clearly for a perfectly competitive market. There is an inherent limitation in the definition of a perfectly competitive market, which precludes the explanation of movement of the market price after an economic shock. In a perfectly competitive market, all producers are price takers and the prices are perfectly flexible, however, a central question to the discussion is: who changes the price after an economic shock to the market to lead to a new equilibrium? If no one changes the price, then supply will never equalize the demand after an economic shock, resulting in an infinite level of inefficiency. If the producers have to be ass
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