Chapter 1

Functions and Roles of the Financial System in the

Global Economy

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Learning Objectives

• To understand the functions performed and the roles played by the system of financial markets and financial institutions in the global economy and in our daily lives.

• To discover how important the financial system is to increasing our standard of living, generating new jobs, and building our savings to meet tomorrow’s financial needs.

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Introduction to the Financial System

The financial system is …

• the collection of markets, institutions, laws, regulations, and techniques

• through which bonds, stocks, and other securities are traded, interest rates are determined, and financial services are produced and delivered around the world.

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Introduction to the Financial System

The primary task of the financial system is … • to move scarce loanable funds • from those who save • to those who borrow to buy goods and services and to make

investments in new equipment and facilities, • so that the global economy can grow and the standard of living

can increase.

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Flows within the Global Economic System

• The basic function of the economic system is to allocate scarce resources – land, labor, management skill, and capital – to produce the goods and services needed by society.

• The global economy generates a flow of production in return for a flow of payments.

• The circular flow of production and income is interdependent and never ending.

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Circular Flow of Income, Payments, and Productionin the Global Economic System

Producing units (mainly business firms

and governments)Consuming units

(mainly households)

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The Role of Markets in the Global Economic System

• Most economies around the world rely principally upon markets to carry out the complex task of allocating scarce resources.

• The marketplace is dynamic. It determines what goods and services will be produced and in what quantities through their prices.

• Markets also distribute income by rewarding superior producers with increased profits, higher wages, and other economic benefits.

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Types of Markets

• There are essentially three types of markets within the global economic system.

The factor markets allocate factors of production (land, labor, skills, capital) and distribute income (wages, rent) to the owners of productive resources.

Consuming units use most of their income from factor markets to purchase goods and services in the product markets.

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Types of Markets

The financial markets channel savings to those individuals and institutions needing more funds for spending than are provided by their current incomes.

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Types of Markets

Producing units (mainly business

firms and governments)

Consuming units (mainly households)

Flow of funds (savings)

Flow of financial services, income, and

financial claims

Financial marketsFlow of p

roduction

Product markets

Goods and servicesFlow of p

ayments

Flow of payments for

consumption and taxes

Flow of incomesFlow of incomes Factor markets

Productive s

ervice

sProductive services

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The Financial Markets and the Financial System:Channel for Savings and Investment

• Nature of savingsHouseholds: current income – tax payments – consumption

expenditures

Businesses: retained earnings

Governments: current revenues – expenditures

• Nature of investmentHouseholds: purchase of a home

Businesses: expenditures on capital goods and inventories

Governments: building/maintaining public facilities

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The Financial Markets and the Financial System:Channel for Savings and Investment

• The financial markets enable the exchange of current income for future income and the transformation of savings into investment so that production, employment, and income can grow, and living standards can improve.

• The suppliers of funds to the financial system expect not only to recover their original funds but also to earn additional income as a reward for waiting and assuming risk.

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The Global Financial System

Flow of financial services, incomes, and

financial claims

Demanders of funds (mainly business

firms and governments)

Flow of loanable funds (savings) Suppliers of

funds (mainly

households)

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Functions Performed by the Global Financial System and the Financial Markets

• Savings function. The global system of financial markets and institutions provides a conduit for the public’s savings.

• Wealth function. The financial instruments sold in the money and capital markets provide an excellent way to store wealth.

• Liquidity function. Financial markets provide liquidity for savers who hold financial instruments but are in need of money.

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Functions Performed by the Global Financial System and the Financial Markets

• Credit function. Global financial markets furnish credit to finance consumption and investment spending.

• Payments function. The global financial system provides a mechanism for making payments for goods and services, in the form of currency, checking accounts, debit cards, credit cards, digital cash, etc.

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Functions Performed by the Global Financial System and the Financial Markets

• Risk protection function. The financial markets offer protection against life, health, property, and income risks, by permitting individuals and institutions to engage in both risk-sharing and risk reduction.

• Policy function. The financial markets are a channel through which governments may attempt to stabilize the economy and avoid inflation.

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Functions Performed by the Global Financial System and the Financial Markets

• The financial services that are most widely sought by the public include:- Payments services- Thrift services- Insurance services- Credit services- Hedging services- Agency services

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Types of Financial MarketsWithin the Global Financial System

• The money market is for short-term (one year or less) loans, while the capital market finances long-term investments by businesses, governments, and households.

• In particular, governments borrow from commercial banks in the money market, while in the capital market, insurance companies, mutual funds, security dealers, and pension funds supply the funds for businesses.

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Types of Financial MarketsWithin the Global Financial System

• The money market may be subdivided into Treasury bills, certificates of deposit (CDs), bankers’ acceptances, commercial paper, federal funds and Eurocurrencies.

• The capital market may be subdivided into mortgage loans, tax-exempt (municipal) bonds, consumer loans, Eurobonds and Euronotes, corporate stock, and corporate notes and bonds.

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Types of Financial MarketsWithin the Global Financial System

• In open markets, financial instruments are sold to the highest bidder, and they can be traded as often as is desirable before they mature. In negotiated markets, the instruments are sold to one or a few buyers under private contract.

• Financial capital is raised when new securities are sold in the primary markets. Security trading in the secondary markets then provides liquidity for the investors.

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Types of Financial MarketsWithin the Global Financial System

• In the spot market, assets are traded for immediate delivery (usually within one or two business days).

• A futures or forward market is designed to trade contracts calling for the future delivery of financial instruments.

• Options markets enable contracts that grant the right to buy or sell certain securities at specific prices within a certain time to be traded.

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Chapter Review

• Introduction to the Financial System• The Global Economy and the Financial System

- Flows within the Global Economic System- The Role of Markets in the Global Economic System- Types of Markets- The Financial Markets and the Financial System: Channel for

Savings and Investment

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Chapter Review

• Functions Performed by the Global Financial System and the Financial Markets- Savings Function- Wealth Function- Liquidity Function- Credit Function- Payments Function- Risk Protection Function- Policy Function

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Chapter Review

• Types of Financial Markets Within the Global Financial System- The Money Market versus the Capital Market- Divisions of the Money and Capital Markets- Open versus Negotiated Markets- Primary versus Secondary Markets- Spot versus Futures, Forward, and Option Markets