Assumptions and Conditions in the Arrow-Debreu Equilibrium Model

In general, there are two ways of financing, direct finance and indirect finance. In direct finance, households directly purchase the securities issued by firms through securities market. Thus, households have to judge and absorb firmЎ¦s credit risks directly. On the other hand, in indirect finance, firmЎ¦s credit risks are judged and absorbed by financial intermediaries who mediate funds collected from households to firms. Both financing methods play an important role in whole economic activities.

Simply speaking, there are four main players involved in financing activities. Each player has different specific functions that related to the others, financing activities would not be able to be held if one of them were not exist. The Arrow-Debreu General Equilibrium model in direct/indirect finance explains the functions of each player, and the relationship between them as shown below.

Arrow-Debreu General Equilibrium Model

Financial Markets

Bf + Bb = Bh

Firms Households

Assets Liabilities Assets Liabilities

Investment I

Securities Bf

Loan L- Securities Bh

Deposits D+ Savings S

Banks

Assets Liabilities

Loans L+ Securities Bb

Deposits D

A. Households

Households are fund provider to other finance player, no matter under which financing way (direct or indirect finance) the fund is provided. From the disposable income that they get, households will allocate some for consumption. The portion that has not been consumed called saving. Then the households can choose their own way of allocating those saving either for bank deposits (D+) or securities (Bh), or maybe both of them in their preferred proportion that can maximize its benefit.

B. Banks

In this model, the role of the bank is as fund provider for firms. Banks extend loans to firms (L+) to meet the firms demand in funds. In some Ў§bank centeredЎЁ countries such as Japan, China, and Indonesia this role become very important. The bank itself rely their funding upon money deposits from households (D-) and securities market (Bb).

C. Firms

In order to make more profit (maximize it), firms need to make investment. However, when it comes to major investments that need large amount of money, firms can not finance those investments by themselves . Investment is funded through loans from banks (L-) or securities market by issuing stock or bonds.

D. Securities Market

In securities market, demand of securities from firms (Bf), as well as those from banks (Bb) meet the supply from households (Bh).

In order to reach the general equilibrium state, there are some conditions that need to be fulfilled in Arrow-Debreu general equilibrium model, and those conditions are :

1. I = S

Investment made by firms has to