Efficient Market Hypothesis and Loanable Funds Theory Explained

Efficient Market Hypothesis (EMH)

The EMH states that at any given time in a liquid market, security prices fully reflect all available information. Markets are efficient, and current prices incorporate all data; therefore, attempts to outperform the market are essentially a game of chance.

Forms of Market Efficiency

• Weak Form: Current stock prices reflect all past trading information. Consequently, fundamental analysis and technical analysis have no predictive power regarding future prices.
• Semi-Strong Form: Current stock prices adjust instantly to the release of all public information. All market and non-market data are factored into the price, making it impossible to achieve excess returns.
• Strong Form: Current stock prices fully reflect all public and private information. This includes market, non-market, and inside information. No investor has monopolistic access to relevant data.

Random Walk Theory

This theory posits that changes in stock prices have the same distribution and are independent of each other. Past movements or trends cannot predict future price action.

The Loanable Funds Theory

The Loanable Funds Theory suggests that market interest rates are determined by the factors that control the supply of and demand for loanable funds.

Demand for Loanable Funds

• Households: Demand funds to finance housing, automobiles, and household items. As interest rates rise, demand decreases; as interest rates fall, demand increases.
• Businesses: Demand depends on the number of viable projects. Lower interest rates reduce the cost of borrowing, lowering the hurdle rate and increasing the number of accepted projects. Higher interest rates increase the hurdle rate, decreasing project acceptance.
• Government: Governments demand funds when planned expenditures exceed incoming revenues. Government demand is interest inelastic, meaning it is insensitive to interest rate fluctuations, as expenditures and tax policies are independent of rate levels.

Market Dynamics

At any given point, if the supply of loanable funds increases, interest rates fall and demand rises. Conversely, if the supply of loanable funds decreases, interest rates rise and demand falls.

Factors Influencing Interest Rates

• Economic Growth: Puts upward pressure on interest rates by shifting the demand for loanable funds outward.
• Inflation: Puts upward pressure on interest rates by shifting the supply of funds inward and the demand for funds outward.
• Monetary Policy: When the Federal Reserve reduces the money supply, it reduces the supply of loanable funds, putting upward pressure on interest rates. Increasing the money supply has the opposite effect.

The Fisher Equation

As inflation rises, purchasing power is reduced. The Fisher Equation represents the relationship between nominal interest rates, expected inflation, and real interest rates:

i = E(INF) + ir