Understanding Financial Markets

This essay provides a non‐technical account of the development of thinking about the ways in which financial markets work. The account is organized by distinguishing between the “financial approach” and the “monetary approach” to the study of financial markets. The financial approach emphasizes the importance of arbitrage in determining financial asset prices. The monetary approach utilizes the more traditional tools of supply and demand, and places greater emphasis on the role of market imperfections. The essay evaluates the contribution of each approach to improving our understanding of financial markets. It concludes that the central problem in financial market research remains that of providing a satisfactory explanation of the determination of asset prices. In the emerging regime of liberalized, competitive financial markets both the financial approach and the monetary approach have a distinctive contribution to make in understanding how these markets work. This paper is based on research funded by the Economic and Social Research Council under grant No. B0023‐2151.