Chapter 1

Functions and Roles of the Financial System in the Global Economy

Slides by Yee-Tien (Ted) Fu

1-3

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 tomorrows financial needs.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1-4

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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1-5

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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1-6

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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1-7

Circular Flow of Income, Payments, and Production in the Global Economic System

Producing units (mainly business firms and governments)

Consuming units (mainly households)

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1-8

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.
McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1-9

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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 10

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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 11

Types of Markets
Product markets

Financial markets Producing units (mainly business firms and governments) Flow of funds (savings) Flow of financial services, income, and financial claims Consuming units (mainly households)

Factor markets
McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 12

The Financial Markets and the 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
McGraw-Hill/Irwin Money and Capital Markets, 9/e 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 13

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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 14

The Global Financial System

Demanders of funds (mainly business firms and governments)

Flow of loanable funds (savings) Flow of financial services, incomes, and financial claims

Suppliers of funds (mainly households)

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 15

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 publics 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 16

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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 17

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

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 18

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

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 19

Types of Financial Markets Within 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 20

Types of Financial Markets Within 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 21

Types of Financial Markets Within 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 22

Types of Financial Markets Within 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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 23

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.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 24

Factors Tying All Financial Markets Together

Perfect and efficient markets. There is some research evidence suggesting that financial markets are closely tied to one another due to their near perfection and efficiency. Financial markets in the real world. In the real world however, market imperfection and information asymmetry exist.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 25

The Dynamic Financial System

The global financial system is rapidly changing. In particular, the trend towards the global integration of financial systems has been aided by the gradual deregulation of financial institutions and services as well as the increasing harmonization of their regulations.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 26

The Dynamic Financial System

The results have been increasingly intense competition, many new financial services, increased risk, and a wave of mergers among financial institutions.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 27

The Plan of This Book

Part One provides an overview of the global financial system its role in the worlds economy and basic characteristics. Part Two examines the forces that shape interest rates and the prices of financial instruments. Part Three draws our attention to the money market and its principal instruments and institutions (including the central bank).

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 28

The Plan of This Book

Part Four takes a closer look at commercial banks, credit unions, savings and loan associations, money market funds, insurance companies, pension funds, mutual funds, and other private financial-service firms. Part Five turns to the role of governments (federal, state, and local) and business firms within the global financial system.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 29

The Plan of This Book

Part Six focuses on the financial characteristics of consumers individuals and families. Part Seven is devoted to the international financial system and future trends in global finance.

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 30

Markets on the Net

Bankrate.com at www.bankrate.com/brm Chicago Board of Trade at www.cbot.com Derivatives Concepts A-Z at www.finpipe.com/derivglossary.htm Moodys Investor Service at www.moodys.com Securities and Exchange Commission at www.sec.gov

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 31

Markets on the Net

Standard and Poors Corporation at www.standardandpoors.com The Financial Times at www.ftbusiness.com The Wall Street Journal at www.wsj.com U.S. Bureau of Economic Analysis at www.bea.gov U.S. Bureau of the Census at www.census.gov

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 32

Markets on the Net

U.S. Treasury Department at www.publicdebt.treas.gov

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 33

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

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 34

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

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 35

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

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.

1 - 36

Chapter Review
Factors Tying All Financial Markets Together
Credit, the Common Commodity Speculation and Arbitrage Perfect and Efficient Markets Financial Markets in the Real World: Imperfection and Asymmetry

The Dynamic Financial System The Plan of This Book

McGraw-Hill/Irwin Money and Capital Markets, 9/e

2006 The McGraw-Hill Companies, Inc., All Rights Reserved.