CHAP 1 Functions and Roles of the Financial System in the Global Economy
Functions and Roles of the Financial System in the Global Economy
Financial Market and Financial System
Channel for Savings and Investment
Nature of savings
Households: current income – tax payments – consumption expenditures
Businesses: retained earnings
Governments: current revenues – expenditures
Nature of investment
Households: purchase of a home
Businesses: expenditures on capital goods and inventories
Governments: building/maintaining public facilities
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 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.
Economic Functions of FMIs
Provides a conduit for the public’s savings
Profitable outlet for utilization of savings
Savings flow through the financial markets to investments allowing the economy to increase production
Provide liquidity for savers who hold financial instruments but are in need of money
Money is mainly currency and deposits held in depository institutions
Can be spent without need of conversion
Earns the lowest rate of return of all financial assets
Wealth is the value of accumulated savings built up over time
Financial instruments provide an excellent way to store wealth
Financial instruments do not depreciate and often generate income
Financial instruments have less risk than many other forms of wealth storing
Financial wealth is extensive
$55 trillion in US financial assets held by domestic nonfinancial businesses
$11 trillion in US financial assets are held by international investors
Furnish credit to finance current consumption and investment spending
Accessed by pledging future income
The flipside of savings
Volume of credit in the United States is huge and growing
Total credit funds raised in the US in 2005 is $3.4 trillion
More than double what it was a decade before
A mechanism for making payments for purchases of goods and services
Certain financial assets have been popular means of exchange (currency, demand deposits, etc.)
Growing in popularity are debit and credit cards
Many other instruments are also growing in popularity (ATM, Stored-value cards, etc.)
Risk Protection Function
The financial markets offer protection against life, health, property, and income risks
Permits individuals and institutions
Engage in risk-sharing
Engage in risk reduction
A channel through which governments may attempt to influence the economy
Affect borrowing and spending plans
Impact the growth rates of jobs, production, and prices
The task of economic stabilization has been given largely to central banks
Types of Financial Markets
The money market is the market for short-term (one year or less) loans.
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.
In open markets, financial instruments are sold to the highest bidder, and can be traded as often as is desirable before maturity.
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.
Factors Tying All Financial Markets Together
Credit, the common commodity. The shifting of borrowers among markets helps to weld the financial system together and to balance the costs of credit in the different markets.
Speculation and arbitrage. Speculators who gamble on their market forecasts and arbitrageurs who watch for profitable arbitrage opportunities help to level out prices and maintain price consistency among the markets.
Dynamic Financial System
The global financial system rapidly changing into a new system
The trend toward global integration of financial systems
Powered by innovations as new financial services and instruments continually appear to attract customers
Non-financial companies invading the financial services field
Aided by the gradual deregulation
Benefiting from increasing harmonization of regulations
The results are major changes to the market
Increasingly intense competition
Many new financial services
A wave of mergers among financial institutions
Division as per the mode of exchange
Commodity Mode of Money
Live stocks, sacks of “cereal” grains (Shekel has come from there)
Cowry shell, beads
Metals (1500BC to 1000 AD)
Bronze, iron, silver, gold
First by Song Dynasty in China during the 11th century and was introduced in Europe in 13th century
Bank came into operations in Italy. First bank to be established was established in Venice with guarantee from the State in 1157.
Barclay Credit Bank of UK first introduced credit card in 1966
Modern Economic Systems
Socialist/Centrally Command Economy
Circular Flow in the Economy
In economics the term circular flow refers to a simple economic model which describes the reciprocal circulation of income between producers and consumers.
In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income
Firms provide consumers with “goods and services” in exchange for consumer expenditure and "factors of production" from households.
The Financial System
A collection of markets, institutions, laws, regulations, and techniques where
Bonds, stocks, and other securities are traded
Interest rates are determined
Financial services are produced
Financial services are delivered around the world
It moves scarce loanable funds.
Funds are shifted from those who save.
The funds are moved to those who borrow to buy goods and services and to make investments in new equipment and facilities.
That movement enables the global economy to grow and the standard of living to increase.
Global Economics System
Flow within Global Economics System
Basic function of the economic system
Allocate scarce resources; land, labor, management skill, and capital
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
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.
3 types of Markets:
The factor markets
Allocate factors of production (land, labor, skills, capital)
Distribute income (wages, rent) to the owners of productive resources
The product markets
Allocate goods and services
Consuming units use most of their income in this market
The financial markets
Allocate savings to individuals and institutions
Those that need more funds for spending than are provided by their current incomes