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Market clearing is a phenomenon which occurs when the supply and demand for something are in perfect balance and thus the market clears, with no excess supply or unfilled demand. Some classical economists believed that economies tended toward a state of market clearing, but today the approach to economics is a bit more complicated. While this situation can occur, it is not necessarily common and it can be affected by a number of factors.
In a simple example of market clearing, imagine that 20,000 people all want to take out loans at five percent interest and five lenders have 20,000 loans available at five percent interest. In this case, the demand for loans equals the supply and the loan market clears. Everyone who wants a loan will get one, and everyone who has a loan to offer will be able to find a borrower to take the loan.
In this case, the market is in a state of equilibrium. Equilibrium can be quickly thrown off, however. In the example above, for instance, if 10,000 people wanted loans at five percent and 10,000 wanted loans at four and a half percent but the lenders were unwilling to budge, the market would not clear. Some people would be left in need of a loan and the lenders would not be able to find enough borrowers for their products.
Price adjustments can be used to control market equilibrium and may be used deliberately for this purpose. For example, if lenders want to tighten the credit market, they can raise interest rates. Demand for loans will decrease because some people cannot afford or are unwilling to pay the higher rate. Conversely, slashing interest rates will increase demand and cause more people to take out loans because they view the low rates as a good deal. In both cases, market clearing does not occur because either supply exceeds demand or demand outstrips supply.
Theorists who support the idea that market clearing is a natural state for an economy argue that it is in the best interests of everyone for the economy to be in equilibrium. However, this may not always be true. There may be cases in which people on one side or the other may benefit from a lack of equilibrium, in fact. For example, people buying homes benefit when interest rates are low, because they can get better loans, but interest rates will not stay low because this does not benefit lenders. As a result, interest rates tend to teeter back and forth, rarely reaching a point of equilibrium where everyone wins.
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