Professional Documents
Culture Documents
5 Financial System
Questions to be answered
Financial Institutions
▪ The financial system: the group of institutions that helps match the
saving of one person with the investment of another.
▪ Financial markets: institutions through which savers can directly
provide funds to borrowers. Examples:
▪ The Bond Market.
A bond is a certificate of indebtedness.
▪ The Stock Market.
A stock is a claim to partial ownership in a firm.
Lender-Savers Borrower-Spenders
1. Households 1. Business firms
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners
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Function of Financial Markets
▪ There exist two different forms of exchange in financial markets.
▪ Direct finance
▪ lenders and borrowers meet directly to exchange securities.
▪ Borrowers borrow directly from lenders in financial markets by selling financial instruments
which are claims on the borrower’s future income or assets.
▪ Indirect finance
▪ borrowers and lenders never meet directly, but lenders provide funds to a financial
intermediary such as a bank or others institutions (Mutual funds, money managers, …).
▪ Borrowers borrow indirectly from lenders via financial intermediaries (established to source
both loanable funds and loan opportunities) by issuing financial instruments which are claims
on the borrower’s future income or assets.
6
Function of Financial Markets 1. Allows transfers of funds from
person or business without
investment opportunities to one
who has them.
2. Improves economic efficiency
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Function of Financial Intermediaries: Indirect Finance
▪ Transaction costs
▪ Economies of scale
1. Financial intermediaries make profits by reducing transactions costs
2. Reduce transactions costs by developing expertise and taking advantage of economies
of scale
▪ Liquidity services
A financial intermediary’s low transaction costs mean that it can provide its customers with
liquidity services, services that make it easier for customers to conduct transactions
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Function of Financial Intermediaries: Indirect Finance
▪ Risk Sharing
1. Create and sell assets with low risk characteristics and then use the funds
to buy assets with more risk (called asset transformation).
2. Lower risk by helping people to diversify portfolios (diversification)
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Function of Financial Intermediaries: Indirect Finance
▪ Asymmetric Information: Financial intermediaries reduce
▪ Adverse Selection
▪ Moral Hazard
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Function of Financial Intermediaries: Indirect Finance
Adverse Selection
1. Before transaction occurs
2. Potential borrowers most likely to produce adverse outcome are ones most likely to seek a
loan
3. Similar problems occur with insurance where unhealthy people want their known medical
problems covered
Moral Hazard
1. After transaction occurs
2. Hazard that borrower has incentives to engage in undesirable (immoral) activities making
it more likely that won't pay loan back
3. Again, with insurance, people may engage in risky activities only after being insured
4. Another view is a conflict of interest
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Classification of financial markets
1. Type of financial claim
• Debt markets
• Equity markets
2. Maturity of the claim
• Money market
• Capital markets
3. Issuance:
• Primary market (newly issued)
• Secondary market (previously issued)
4. Time of the transaction:
• Cash market
• Derivatives market (The contract holder buys or sells a financial instrument at
some future time)
5. Organizational structure:
• Auction market /organized Exchange
• Over-the-counter market 13
Commercial Bank
Credit Unions
Specialized Banks
Contractual
Financial
Intermediaries savings Insurance Companies
Institutions
Pension Funds
Finance Companies
Investment
Intermedaries Mutual Funds (Investment Funds)
Is the total income in the economy that remains after paying for
consumption and government purchases, which is called national saving
or saving. Principles of Economics M. ISLEIMEYYEH 15
CH.5 Saving, Investment, and Financial System
▪ Let T denote the amount that the government collects from households in taxes
minus the amount it pays back to housholds in the form of transfer payments,
e.g., Social Security.
S=Y–C–G
S = (Y – T – C) + (T– G)
▪ Private saving
= The portion of households’ income that is not used for consumption or paying taxes
= Y–T–C
▪ Public saving
= Tax revenue less government spending= T – G
▪ National saving
= private saving + public saving
= (Y – T – C) + (T – G)
= Y – C – G
= the portion of national income that is not used for consumption or government purchases
▪ Budget deficit
= a shortfall of tax revenue from government spending
= G–T
= – (public saving)
ACTIVE LEARNING
A. Suppose GDP equals $10 trillion, consumption equals $6.5 trillion, the government
spends $2 trillion , and has a budget deficit of $300 billion.
▪ Find public saving, taxes, private saving, national saving, and investment.
Given:
Y = 10.0, C = 6.5, G = 2.0, G – T = 0.3
A C T I V E L E A R N I N G (Cont.)
A C T I V E L E A R N I N G (Cont.)
B. Use the numbers from the preceding exercise, but suppose now that the government cuts taxes by
$200 billion.
▪ In each of the following two scenarios, determine what happens to public saving, private saving,
national saving, and investment.
1. Consumers save the full proceeds of the tax cut.
2. Consumers save 1/4 of the tax cut and spend the other 3/4.
Answers
In both scenarios, public saving falls by $200 billion, and the budget deficit rises from $300 billion
to $500 billion.
1. If consumers save the full $200 billion, national saving is unchanged, so investment is
unchanged.
2. If consumers save $50 billion and spend $150 billion, then national saving and investment each
Principles of Economics M. ISLEIMEYYEH 21
fall by $150 billion.
CH.5 Saving, Investment, and Financial System
60 80 Loanable Funds
($billions)
Principles of Economics M. ISLEIMEYYEH 27
CH.5 Saving, Investment, and Financial System
Demand
50 80 Loanable Funds
($billions)
Principles of Economics M. ISLEIMEYYEH 29
CH.5 Saving, Investment, and Financial System
60 Loanable Funds
($billions)
Principles of Economics M. ISLEIMEYYEH 30
CH.5 Saving, Investment, and Financial System
▪ If the interest rate were higher than equilibrium, there would be a surplus of
funds. The interest rate would fall to restore equilibrium.
60 70 Loanable Funds
Principles of Economics
($billions)
M. ISLEIMEYYEH 32
CH.5 Saving, Investment, and Financial System
60 70 Loanable Funds
($billions)
33
CH.5 Saving, Investment, andInvestment,
Saving, Financial and
System
the Financial System
Thank you