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 tomorrow’s financial needs.

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

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

laws. regulations. All Rights Reserved. and other securities are traded. Inc. McGraw-Hill/Irwin Money and Capital Markets. interest rates are determined. 9/e © 2006 The McGraw-Hill Companies.. and financial services are produced and delivered around the world. and techniques • through which bonds. stocks. . institutions.1-4 Introduction to the Financial System The financial system is … • the collection of markets.

.. McGraw-Hill/Irwin Money and Capital Markets. 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. 9/e © 2006 The McGraw-Hill Companies. Inc. • so that the global economy can grow and the standard of living can increase.

1-6 Flows within the Global Economic System • The basic function of the economic system is to allocate scarce resources – land. 9/e © 2006 The McGraw-Hill Companies. • 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. labor. Inc. and capital – to produce the goods and services needed by society. All Rights Reserved.. management skill. .

All Rights Reserved. . Inc.. Payments.1-7 Circular Flow of Income. 9/e © 2006 The McGraw-Hill Companies. 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.

• Markets also distribute income by rewarding superior producers with increased profits. . Inc. 9/e © 2006 The McGraw-Hill Companies. • The marketplace is dynamic. 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. It determines what goods and services will be produced and in what quantities through their prices. higher wages. McGraw-Hill/Irwin Money and Capital Markets. and other economic benefits.

McGraw-Hill/Irwin Money and Capital Markets. labor. Inc. capital) and distribute income (wages.  The factor markets allocate factors of production (land.1-9 Types of Markets • There are essentially three types of markets within the global economic system. All Rights Reserved. rent) to the owners of productive resources. . skills..  Consuming units use most of their income from factor markets to purchase goods and services in the product markets. 9/e © 2006 The McGraw-Hill Companies.

1 . Inc. .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.. All Rights Reserved. 9/e © 2006 The McGraw-Hill Companies. McGraw-Hill/Irwin Money and Capital Markets.

.1 . income. All Rights Reserved.. 9/e © 2006 The McGraw-Hill Companies. and financial claims Consuming units (mainly households) Factor markets McGraw-Hill/Irwin Money and Capital Markets.11 Types of Markets Product markets Financial markets Producing units (mainly business firms and governments) Flow of funds (savings) Flow of financial services. Inc.

. 9/e © 2006 The McGraw-Hill Companies. .1 . All Rights Reserved. Inc.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.

1 . and living standards can improve. All Rights Reserved. 9/e © 2006 The McGraw-Hill Companies. • 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. and income can grow.. employment.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. Inc. .

incomes. Inc.14 The Global Financial System Demanders of funds (mainly business firms and governments) Flow of loanable funds (savings) Flow of financial services. 9/e © 2006 The McGraw-Hill Companies.. and financial claims Suppliers of funds (mainly households) McGraw-Hill/Irwin Money and Capital Markets. All Rights Reserved.1 . .

All Rights Reserved.. The global system of financial markets and institutions provides a conduit for the public’s savings. . • Liquidity function. • Wealth function. The financial instruments sold in the money and capital markets provide an excellent way to store wealth. Financial markets provide liquidity for savers who hold financial instruments but are in need of money.1 . Inc. McGraw-Hill/Irwin Money and Capital Markets.15 Functions Performed by the Global Financial System and the Financial Markets • Savings function. 9/e © 2006 The McGraw-Hill Companies.

1 . credit cards. McGraw-Hill/Irwin Money and Capital Markets. checking accounts. in the form of currency. All Rights Reserved. Inc. digital cash. The global financial system provides a mechanism for making payments for goods and services. etc. debit cards.16 Functions Performed by the Global Financial System and the Financial Markets • Credit function. • Payments function. 9/e © 2006 The McGraw-Hill Companies. . Global financial markets furnish credit to finance consumption and investment spending..

The financial markets offer protection against life.. McGraw-Hill/Irwin Money and Capital Markets. All Rights Reserved. . by permitting individuals and institutions to engage in both risksharing and risk reduction. The financial markets are a channel through which governments may attempt to stabilize the economy and avoid inflation. property.1 .17 Functions Performed by the Global Financial System and the Financial Markets • Risk protection function. and income risks. 9/e © 2006 The McGraw-Hill Companies. Inc. health. • Policy function.

All Rights Reserved. . 9/e © 2006 The McGraw-Hill Companies.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. Inc..1 .

mutual funds. governments. insurance companies. security dealers.1 . Inc. • In particular.19 Types of Financial Markets Within the Global Financial System • The money market is for short-term (one year or less) loans. and households. while in the capital market. 9/e © 2006 The McGraw-Hill Companies. McGraw-Hill/Irwin Money and Capital Markets. and pension funds supply the funds for businesses.. All Rights Reserved. while the capital market finances long-term investments by businesses. . governments borrow from commercial banks in the money market.

. 9/e © 2006 The McGraw-Hill Companies.20 Types of Financial Markets Within the Global Financial System • The money market may be subdivided into Treasury bills. consumer loans. McGraw-Hill/Irwin Money and Capital Markets. federal funds and Eurocurrencies. All Rights Reserved. . Eurobonds and Euronotes. • The capital market may be subdivided into mortgage loans. certificates of deposit (CDs). Inc. and corporate notes and bonds.1 . bankers’ acceptances. tax-exempt (municipal) bonds. commercial paper. corporate stock.

financial instruments are sold to the highest bidder. Inc. • 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.21 Types of Financial Markets Within the Global Financial System • In open markets. .. All Rights Reserved. 9/e © 2006 The McGraw-Hill Companies. the instruments are sold to one or a few buyers under private contract. and they can be traded as often as is desirable before they mature. In negotiated markets. McGraw-Hill/Irwin Money and Capital Markets.1 .

22 Types of Financial Markets Within the Global Financial System • In the spot market. McGraw-Hill/Irwin Money and Capital Markets. 9/e © 2006 The McGraw-Hill Companies. Inc. • Options markets enable contracts that grant the right to buy or sell certain securities at specific prices within a certain time to be traded..1 . 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. . All Rights Reserved.

.23 Factors Tying All Financial Markets Together • Credit. The shifting of borrowers among markets helps to weld the financial system together and to balance the costs of credit in the different markets. 9/e © 2006 The McGraw-Hill Companies. 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. the common commodity. • Speculation and arbitrage. All Rights Reserved. Inc. . McGraw-Hill/Irwin Money and Capital Markets.1 .

. 9/e © 2006 The McGraw-Hill Companies.1 . • Financial markets in the real world. Inc.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. . McGraw-Hill/Irwin Money and Capital Markets. market imperfection and information asymmetry exist. In the real world however. All Rights Reserved.

. • In particular.1 . 9/e © 2006 The McGraw-Hill Companies. 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.25 The Dynamic Financial System • The global financial system is rapidly changing. . McGraw-Hill/Irwin Money and Capital Markets. Inc. All Rights Reserved.

many new financial services. All Rights Reserved. 9/e © 2006 The McGraw-Hill Companies.26 The Dynamic Financial System • The results have been increasingly intense competition. McGraw-Hill/Irwin Money and Capital Markets. and a wave of mergers among financial institutions. increased risk..1 . Inc. .

• Part Two examines the forces that shape interest rates and the prices of financial instruments. McGraw-Hill/Irwin Money and Capital Markets. 9/e © 2006 The McGraw-Hill Companies. • Part Three draws our attention to the money market and its principal instruments and institutions (including the central bank). Inc.27 The Plan of This Book • Part One provides an overview of the global financial system – its role in the world’s economy and basic characteristics..1 . . All Rights Reserved.

insurance companies. . • Part Five turns to the role of governments (federal. state. and other private financial-service firms. savings and loan associations.28 The Plan of This Book • Part Four takes a closer look at commercial banks. McGraw-Hill/Irwin Money and Capital Markets. All Rights Reserved. mutual funds. and local) and business firms within the global financial system. pension funds. 9/e © 2006 The McGraw-Hill Companies. credit unions.1 .. money market funds. Inc.

• Part Seven is devoted to the international financial system and future trends in global finance. All Rights Reserved. ..1 . Inc. 9/e © 2006 The McGraw-Hill Companies.29 The Plan of This Book • Part Six focuses on the financial characteristics of consumers – individuals and families. McGraw-Hill/Irwin Money and Capital Markets.

30 Markets on the Net • Bankrate. .gov McGraw-Hill/Irwin Money and Capital Markets. All Rights Reserved. Inc.com at www.com/brm • Chicago Board of Trade at www..com • Securities and Exchange Commission at www.moodys.com/derivglossary.finpipe.com • Derivatives Concepts A-Z at www. 9/e © 2006 The McGraw-Hill Companies.1 .htm • Moody’s Investor Service at www.bankrate.cbot.sec.

1 .ftbusiness. 9/e © 2006 The McGraw-Hill Companies.com • U.census.standardandpoors.. Inc.S. Bureau of the Census at www.gov McGraw-Hill/Irwin Money and Capital Markets.bea.S.com • The Financial Times at www. .com • The Wall Street Journal at www. Bureau of Economic Analysis at www. All Rights Reserved.wsj.31 Markets on the Net • Standard and Poor’s Corporation at www.gov • U.

Inc.treas. 9/e © 2006 The McGraw-Hill Companies. All Rights Reserved. .32 Markets on the Net • U. Treasury Department at www.publicdebt.gov McGraw-Hill/Irwin Money and Capital Markets.1 .S..

. Inc. 9/e © 2006 The McGraw-Hill Companies. All Rights Reserved.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..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..1 . Inc. 9/e © 2006 The McGraw-Hill Companies. All Rights Reserved. .

1 . 9/e © 2006 The McGraw-Hill Companies. Forward. .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. and Option Markets McGraw-Hill/Irwin Money and Capital Markets.. All Rights Reserved. Inc.

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.1 .36 Chapter Review • Factors Tying All Financial Markets Together Credit.. All Rights Reserved. . Inc.

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