Question

What approaches do banks use to determine pricing and how changes in pricing impact on microeconomic market model

Answer 1

In this case, pricing by banks might refer to the interest rates set by the banks on deposits as well as interest charged on giving out loans to the customers (It is the interest rate difference on loans and that on deposits which generates profits for the banks).

Now banks offer a certain interest rates to those who deposit their savings with the banks. This interest rate is usually lower than the one the banks charges from the customers who have taken loans from the banks. It is the interest rate which induces the customers to park their saving funds with the banks.

On the other hand, banks use the initial deposits with them to loan out to the customers. The amount of loans generated can be multiple times(credit multiplier times) the amount of initial (primary) deposits. This is known as credit creation by the banks. The interest rate charged by the banks on the loans is determined by the following factors:-

a. It is usually greater than the interest rate charged by the banks on saving deposits of the customers.

b. The monetary policy of the country determines the level of interest rates in the economy. If expansionary monetary policy is being followed in the country/economy, banks are directed to lower the interests rates for the grant of loans. On the other hand,if contractionary policy is being followed, banks are directed to raise the interest rates so that the demand of loans in the economy is less which will reduce the level of investment and consequently the level of AD in the economy.

Impact of change in pricing on micro economic market model:

Micro economic market model works on the principle of demand and supply curves. It is the the demand and supply curves in the economy which determine the level of equilibrium prices in the economy.

Case 1: Now let us suppose that banks are directed to lower their interest rates on loans (so that expansionary monetary policy is implemented), this will induce more customers to apply for loans. This will raise the level of investment in the economy and the level of aggregate demand as well. Two situations will arise in this case:

a. If the economy is operating on full employment level, then the increase in aggregate demand will not lead to increase in aggregate supply in the economy.This will raise the prices in the economy (this can be explained using the demand and supply curves).

b.If the economy is operating on under employment level, the the increase in aggregate demand will lead to increase on aggregate supply and consequently general price level will not rise. only the equilibrium quantity will rise.

Case 2: Now let us suppose that the banks are directed to raise their interest rates to reduce the demand for loans in the economy. This will lead to decrease in the investment activity and lower the level of aggregate demand in the economy.

This will lead to lowering of price level in the economy.