Nature of the elasticity of demand:

The nature of elasticity of demand for banking products is varied from product to product.
However, this analysis is done with regard to the key three banking products. That is fixed
deposits, savings deposits and loans. When customers supply money to banks in the way of
deposits, banks pay an interest for that and when customer’s demand loans for their needs bank
supply money for which customers pay an interest.

The needs of customers from banking are in two folds; the need of consumption and need of
saving. When it comes to need to consumption, there will be high liquidity of such deposit
accounts and hence the customers may expect a lower interest for such deposits. However, when
the need is saving, the customers supply money for a higher interest rate. Further when supplying
money through a fixed deposits (that is money is deposited for a period of time) customer
expects a higher interest rate as the need of having such product is to improve their funds/wealth.

On the other side, banks are profit earning entities. Hence the banks act as profit maximizing
need while consumer acts maximizing the opportunity cost of their investment. In this context,
banks should provide an appropriate interest rate that will meet customer needs while ensuring
coverage the cost that banks has to incur, i.e., the cost of interest for deposits and their operating
cost.

As a result, the deposits are demanded by banks at a rate that it covers the bank’s marginal
interest cost whereas the consumer will supply money for deposits at a rate that maximizes their
opportunity cost. This will defines the demand and supply curve for deposit accounts and the
equilibrium point of these two curves is the rate at which the deposit will be made

The profit is maximized by banks largely through their loan products which are supported by the
deposits and reserves of the banks.

As per the economic theory, demand elasticity can be defined for a product in different ways
based on the sensitivity of its demand in relation to the change in price/interest rate;

%∆Quantity Demand

ED = %∆Price/Interest rate
The demand in relation to interest rate of the above discussed three deposit products work
differently given different consumer needs behind each product.

Ex; deposit products for consumption needs will have a lesser correlation with the interest rate as
the need of having such account is to withdraw money for their consumption needs and hence
high liquidity is expected. In some cases, even with a very low interest rate customers will have
such deposit accounts with banks to fulfill their need. The demand curve for that deposit product
will be negative – relatively inelastic  ED = <1

However, in the case of deposit products opened for saving purposes, the demand will be elastic
than that of the products that are maintained by customers for consumption purposes. Hence, the
demand curve of such deposit products will be negative and unit elastic  ED = 1

Further, with regard to fixed term deposit products would demand a higher interest rate and
hence the correlation with the interest will be much higher. The demand elasticity of such
products will be negative- relative inelastic  ED = >1

Accordingly, fixed term deposit products are sensitive to interest rate than other two deposit
products.
ntroduction
Elasticity of demand refers to the “degree to which quantity demanded changes due to a change
in price or any other factors that influence the demand for the product” (Hall 2). There are three
types of elasticity of demand which include price elasticity of markets, income elasticity of
markets, and cross elasticity of markets.

The banking industry generates its income mainly from charging interest rates when lending
loans and mortgages, foreign exchange dealings, and other money market factors.

Price Elasticity of Markets in the Banking Industry

Price elasticity of markets “refers to the degree of change in quantity demanded or supplied of a
commodity due to a change in price of the commodity” (Hall 10) The formula is:

P.E.D = proportionate change in quantity demanded or supplied

Proportionate change in price

Price elasticity of markets in the banking industry influences such issues as foreign exchange,
housing, mortgages and also issues of lending rates.

For example, the housing industry consists of houses that are already in the markets for sale, and
those buyers would be willing to purchase. Factors that influence the economy would influence
the lending rates to be used. If there is an excess demand for the homes, prices would increase, as
a result. Since people always purchase hoses, it makes the price elasticity to be highly elastic.

When factors influencing the economy, such as inflation, grow, the lending rate has to be
increased to discourage people from borrowing. The general prices would also increase due to
the inflation, thus, lowering the quantity demanded.

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Mortgage interest rates affect the price elasticity of houses. When the prices are low, consumers
demand more homes since they don’t shy away from the prices that are offered. Price elasticity
of markets influences interest rates, and would influence the monetary and fiscal policies.
Interventions of monetary and fiscal policies may have an effect of a downturn or may boost the
economy depending on the lending rates.

Income Elasticity of Markets

Hall describes income elasticity of markets as the responsiveness of the quantity demanded and
supplied due to the change in the consumer’s real income while keeping other factors constant
(p, 10). It is calculated as

Y.E.D=proportionate change in quantity demanded

Proportionate change in income

The income elasticity of markets has an effect on the deposit and lending decisions of the
economy. Households earning high incomes would deposit more in both the depository and non
depository institutions. Factors of the banking industry influencing spending ability, such as
taxation and lending rates would have major influences.

An increase in interest rates would stimulate more savings and people would spend less. Interest
rates also have an effect on the cost of funding operating debt schemes, such as bank loans and
mortgages. For instance, an increase in the lending rates will shift the funds of consumers
towards the high mortgage and loan payments, and they would shy away from spending.

Cross elasticity of markets

Hall calls cross elasticity as the responsiveness of quantity demanded of a product x due to
change in price of related product y. These products can either be substitutes or complementary
(13).

Consumers are increasingly choosing to obtain loans from non-depository institutions.

According to the current statistics, only 41 % of consumer loans were taken from depository
institutions. This shows the substitution effect of cross elasticity of markets (13).
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