Dep’t of Accounting and Finance Chapter 1 The Role of Financial System in the Economy

CHAPTER ONE
The Role of f Financial System in the Economy
I. General (Overview)
The financial system is a collection of markets, institutions, laws & regulations and techniques through
which bonds, stocks, and other securities traded, interest rates determined, and financial services
produced and delivered. The financial system of nations might be either bank based financial system,
for instance, in the case of Ethiopia or market based financial system in modern economies. In spite of
the differences, the primary task of financial systems is to move scarce Loanable funds from those
who have saved to those who borrow for consumption & investment.
 It makes funds available for lending & borrowing (credit)
 It is the means to reach the level of economic development nowadays enjoyed by advanced
economies.
 The financial system determines:
 the cost of credit, and
 how much credit will be available to pay for goods/services
 The events in the financial system have powerful impact upon the health of the nation's economy.
 When credit becomes more costly and less available, then
 Total spending for goods & services falls
 Businesses cut back production and reduce their investment, because of which unemployment
raises & the economy's growth slows down.
 In contrast, when the cost of credit declines and loan able funds become more readily available
 Total spending in the economy increases
 More jobs are created
 The economy's growth accelerates
 Truly speaking, the financial system is an integral part of the economic system and cannot be
viewed in isolation from it.
 With regard to the impacts of financial operations in the economic system, there are two
fundamental scenarios (arguments). These are the Money Expansion Scenario and the Liquidity
(Keynesian) Scenario.
 According to the Liquidity (Keynesian) scenario, increases in the financial operations in an
economy increases liquidity in the society. Certainly, liquidity increases spending as people can
exchange easily and frequently funds for various purposes.
 According to the Money Expansion Scenario, increases in financial operations increases spending
in the society, which, in turn, increases the investment activity in the same. The diagram in the
next page depicts the aspects (arguments) of the Money Expansion Scenario.

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Dep’t of Accounting and Finance Chapter 1 The Role of Financial System in the Economy

FINANCIAL OPERATIONS IN THE ECONOMY

(Money Expansion Scenario)

FINANCIAL ECONOMIC
SYSTEM SYSTEM

Prices of
Stock of Money Goods and Amount of
Money Velocity Services Goods and
(M ) Services
(V ) (P )
(Y )
Figure 1
= )
MV PY

Increase in money
M V = PY Velocity (V) increases the
Prices of Goods &
Services in the Short-run
Operations in the (P Y )
Financial System Short run Effect
Increases Money
Velocity (V) and
hence, enables
money Expansion
( M V) In the Long run period, the
increase in the Prices of Goods &
M V = PY Services motivates (initiates)
sectoral units to make investments
in real assets. This, in turn,
increases productivity in the
Long run Effect economy and the amount of Goods
& Services produced (Y) thereby.
(PY)

Conclusion
The ultimate effect of Financial Operations is to increase the investment activity in
the Economy/Society and bring welfare by increasing the level of goods & services
provided to the needy.

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Dep’t of Accounting and Finance Chapter 1 The Role of Financial System in the Economy

II. Flows with in the Economic System

The basic function of any economy is to allocate scarce material resources in order to produce the
goods and services needed by society. The standard of living in the society depends fundamentally up
on the ability of the nation's economy to turn out each day the enormous volume of clothing, food,
shelter, and other essentials for living.
This is an exceedingly complex task in bringing high standard of living because,
 First, scarce resources must be procured (obtained) in just the right amounts to provide the
raw materials of production, and
 Second, they must be combined at just the right time with labor and capital to generate the
products & services demanded by consumers
In short, any economic system must combine "inputs"- land and other natural resources, labor and
managerial skills, and capital equipment - in order to produce outputs in the form of goods & services
and provide to the society. This implies that the economy generates a flow of production (goods &
services) in return for a flow of payments. The flow of payments and production with in the economic
system may be considered to be acicular flow between
 Producing units - mainly businesses and governments, and
 Consuming units - principally households

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Dep’t of Accounting and Finance Chapter 1 The Role of Financial System in the Economy

FLOWS IN THE ECONOMIC SYSTEM

 Land, Flow of Products Goods & Services

 Labor & provided to the public
Managerial skill, by combining the
 Capital Flow of Payments basic inputs

Circular Flow (Inter-dependent and Never ending Process

Expend on Goods & Services (stimulating Production)

Purchase of Goods & Services

Producing Units in the Consuming Units in the

Economy (Sectoral Economy (Mainly
Units) Households)
 Business Firms  Individuals
 Governmental Units  Families in the society

Provide Productive services

(Land, labor, capital)

Receive Income
(Wage, Dividend, Rent, Interest)
In modern economies, households provide labor, managerial skills, and natural resources to business
firms and governments in return for income in the form of wages, rents, dividends, and so on.
Most of the income received by households is spent to purchase goods & services. The result of this
spending is a flow of funds back to producing unity's as income, which stimulates the producing units
to produce more goods & services in future periods
The circular flow of production and in come is, thus, inter-dependent and never ending.
III. The Role of Markets in the Economic System
A market is an institution set up by society to allocate resources that are scarce relative to the demand
for them. Markets are the channel through which buyers and sellers meet to exchange goods, services,
and resources. In most economies around the world, markets are used to carry out this complex task of
allocating resources and producing goods & services.
Of course, scarce resources may be allocated by government order and central planning as well. For
example, in command economies - resources flow to those uses predetermined by a central
government plan. Most industrialized western economies use markets to allocate the majority of their

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Dep’t of Accounting and Finance Chapter 1 The Role of Financial System in the Economy
scarce resources today with government directed planning operation side by side. These economies are
really mixed.
In market based economies it is the market place that determine what goods & services to be produced
and in what quantity. This is accomplished essentially through changes in the prices of goods and
service offered in the market.
If the price of a commodity rises, this
 Stimulates business firms to produce and supply more of it to consumers
 In the long run, new firms may enter the market to produce such goods & services
experiencing increased demand and rising prices.
A decline in price, on the other hand, usually leads to reduced production of a good or service, and in
the long run some firms will leave the market place.
Markets also distribute income. In a pure market system, the income of an individual or a business
firm is determined solely by the contribution each makes to production. With increased profits, higher
wages, and through other economic benefits markets reward superior: Productivity, Innovation and
Sensitivity to customer needs
IV. Type of Markets
There are essentially three types of markets at work with in the economic system
1. Factory markets,
2. Product markets, and
3. Financial markets
In factor markets, consuming units sell their labor, managerial skill, and other resources to those
producing units offering the lightest price. The factor markets allocate factors of production such as
land, labor, and capital and distribute income in the form of wages, rental income, and so on to the
owners of productive resources.
Consuming units use most of their income obtained from the factor markets to purchase goods &
services in the product markets.
Food, shelter, automobiles, etc are among the many goods and services sold in the product markets.
While looking the economic system as a whole and the resource allocation role of markets, truly
speaking, we will find the financial system being an integral part therein, which, in fact, can not be
viewed in isolation in the due process.
 The financial system itself is a collection of markets, institutions, laws, regulations, and
techniques through which bonds, stocks, and other securities are traded, interest rates
determined, and financial services produced and delivered in the economy.
In this regard, in addition to the two common types of markets, namely Factor Markets and Product
Markets, that are functional in almost all economies in the world, the financial system alone brings
another third category of markets in the economic environment, which is collectively referred to as
“Financial Market”. This latter category of markets, though had been introduced during the imperial
regime, are virtually absent in the Ethiopian Financial system since 1974.
Regarding resource allocations, as factor and product markets do, financial markets as well perform
vital functions within the economic system in allocating and/or channeling surplus funds of savers to
those who need more funds for spending/investment.

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Dep’t of Accounting and Finance Chapter 1 The Role of Financial System in the Economy
Deeply subsiding into the heart of the financial system, thus, financial markets strategically serve as
inlet and outlet valves in allocating the most liquid, fragile, and risky resource money, which is a
measure of both real and financial wealth in the economy. In doing so, the financial markets help in
sufficiently attracting surplus savings of the public, determining the volume of credit available in the
economy, and setting interest rates and security prices.
In fact, as we have differences in the features & operations of economic systems among nations, there
are also differences in the features and operations of financial systems. In aggregate, financial systems
prevailing among nations in the world could be described as either "Market based" or "Bank based".
The practices and experiences of most modern western economies, in this regard, might be typical
examples for market based financial systems, which depend on the operations of financial markets
that are giving secondary market opportunities for outstanding financial instruments. In contrast, bank
based financial systems are those solely relaying on the operations of financial intermediaries and
financial middlemen for channeling funds in the economy. These are only providing primary market
opportunities for new issues and do not have mechanisms to allow secondary trading on old securities
among the public. The features of the existing financial system in Ethiopia, which is dominated by the
operations of a few commercial banks, insurance companies, and thrift institutions, might be a very
elementary and poor reference in describing channel based financial systems. In fact, bank based
systems are even more sophisticated than what we currently have in Ethiopia.
In spite of this, the operations of financial markets in market based financial systems enhance the
channeling of net savings in the society into net investment in the society, thereby enhancing the
process of resource allocation and making the savings-investment cycle complete.
In this regard, in most developed as well as in some developing nations, the establishment, growth,
and prosperity of financial markets have contributed a lot to their national economy. These secondary
markets have better played in the process of resource allocations at large and efficiently linked savings
and investments in particular in their respective economies.
Of course, such markets are said to be the fine tuning instruments operating with in an economy in
order to linking ultimate savers and investors in real assets, both timely and efficiently. If an
economic system is presumed to be a typical synonym to a living human being,
 The cells & tissues represent the saving-surplus units, i.e. households, in the economy;
 The organs represents the saving-deficit units, i.e. investing units, in the economy;
 The bones represent laws, rules, and regulations;
 The muscles & flesh represent real wealth created in the economy; and
 The blood system represents the financial system, whereby: arteries and veins are fund-
channeling institutions, the inlet and outlet valves operating inside the heart are financial
markets, and the life giving blood that dynamically circulates is money.
The continued, normal, and healthy survival of a human being that is linked with the synergetic
coordination of the indicated biological components could be a parable of efficiently operating
economic system, which, in turn, bring about enhancements in the general welfare of households.
Among other things, as the failure of valves operating inside the heart of a human being puts his/her
survival in question, inefficiencies in the operations of financial markets, let alone their absence, in the
financial system presumably challenges the existence of any national economic unit as a going
concern. In worst situations, this may force it to enter in to a state of “comma”.

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In this regard, the survival of a financial system devoid (empty) of the essential valves, as is the case in
the Ethiopian context, seems to be miraculous.
 In fact, the current survival of the domestic economy is not ensured by its internal capabilities
and strengths; rather with the help of instantaneous injections of blood, i.e. funds, from other
capable economies in the globe.
 The implications of this is that, without creating financial markets in the financial system, the
economy could not be able to stand alone and survive in the swift and dynamically changing
global economic orders.
 Thus, the system should enable the participation of the majority of households in building
strong economy, through realization of financial markets to ensure efficient flow of funds
among economic units.
The holistic effects, which go beyond the sum effect of its individual components, in this regard, can
be realized if and only if the modus operation of the domestic financial system is synchronized to such
socio-economic settings. To create such a setting, however, we need to build first the house for the
main players that ever strive to bring efficiency in the flow of funds with in any economic system, i.e.
financial markets.

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Dep’t of Accounting and Finance Chapter 1 The Role of Financial System in the Economy

OPERATIONS OF MARKETS IN THE ECONOMY

FACTOR
MARKET
Inputs (Markets for Land,
Labor & Managerial skill, Flow of Income
Flow of Income Capital)

Flow of productive services

Flow of productive services

Claims Claims
CONSUMING FINANCIAL
UNITS MARKET PRODUCING
(Saving-Surplus Units) Flow of financial UNITS
services, claims, and (Saving-Deficit Units)
funds)
Surplus Funds Surplus Funds

Flow of production Flow of production

Flow of Payments
PRODUCT Flow of Payments
MARKET
Final Outputs (Markets
for Goods & Services)

Note that households spend not all factor income for consumption purposes. Moreover, he savings
made by sectoral units may not be sufficient for their investment needs. Thus, financial markets
located and operating in the heart of the financial system, channel surplus funds from savers
(households) to investing units (sectoral units). Financial Markets, therefore,
 Attract excess savings
 Determine volume of credit available
 Determine interest rates and security prices in the economy

V. The Financial Markets and the Financial System

 Of course, households do not consume all factor income.
 A substantial proportion of after tax income received by households each year may be
saved.
 Business firms save to build up equity reserves (undistributed earnings set aside) for
future contingencies and to support long-term investment.
It is here that the third kind of market, the financial market, performs a vital function with in the
economic system.

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The financial market are the heart of the financial system, Determining the volume of credit available
attracting savings and Setting interest rates & security prices. Moreover, it is extremely hypothetical,
to expect and see every economic unit around the globe being self-sufficient in its savings and
investment process as well as efficient in utilization of scarce resources. Seemingly, it is a natural
socio-economic order in that, most often resource allocations and transactional games in almost all
economies and among economic units end up with an imbalance prevailing between demand for
(desire to possess) resources and what is actually possessed during a given period of time.
Although the game is a zero sum when viewed for the economy as a whole, individual economic
units often end up either with surplus funds or deficits arising from transactions made among them.
In this regard, in modern economies, Those economic units ending up with surpluses are most of the
time households; Whereas, those ending up with deficits are investing units, who involve in capital
formation and creation of real wealth in the economy
Had those parties ended up with surpluses were the same as those engaged in investment process,
Every economic unit would have been self-sufficient, Never worried about and needed mechanisms
for allocation of funds in the economy, and also. The economy could have prospered without financial
markets, which are, of course, aiming at bringing efficiency in the economy through linking ultimate
savers and ultimate investors and hence, properly channeling surplus funds to deficit spending units
thereby.
However, the diverse patterns of desired savings and investments among economic units in modern
economies have resulted in greater need for institutions efficiently channeling savings to ultimate
users. In reality, almost all economic units often experience situations whereby large gaps prevail in
their expected investment requirements and the actual level of savings accumulated over time. As a
result, these economic units would be forced to narrow and/or fully bridge the existing gap through
involving in lending and borrowing activities to attain goals, objectives, and meet expectations. This,
in turn, necessitated the search for remedial mechanisms in the contemporary socio-economic
dynamics existing in the globe.
Realizing this situation, economies around the globe have devised financial markets as mechanisms to
channel funds, the practice of which dates back to the mid-18th C. Many of the developed as well as
some of the developing nations have, in this regard, early recognized the fact and given strategic
priority to designing and realizing financial markets in their respective economies. These nations have
benefited a lot and will continue to ripe its potential advantages in the foreseeable period. Nations in
the African continent too have considered the issue long ago and some, of course, have realized their
plans. It initially had seemed a simple fantasy to think about financial markets in the African
continent, however.
VI. Savings and Investment
The definition of savings differs depending upon what type of unit in the economy is doing the saving.
i. Household unit savings is what is leftover out of current income after current consumption
expenditures are made.
ii. Sectoral units
a. Business sector - savings include current net earnings retained in the business after
payments of taxes, stockholders dividends, and all other cash expenses
b. Government sector - saving arises when there is a surplus of revenges over
expenditures.
 Most of the funds set aside as savings flow through the financial markets to support investments,
which refers to acquisition of capital goods. However, household purchase of furniture,

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automobiles, and other durable consumer goods are generally classified as consumption spending
(i.e. expenditures current account) and not investment (i.e. expenditures on capital account)
 Business firm investment - refers to expenditures on fixed assets such as buildings, equipment,
and inventories. Government investment refers spending for public facilities.
 Modern economies require enormous amounts of investment in capital goods in order to produce
goods & services for consumers.
 Investment in new equipment increases the productivity of labor and ultimately leads to a
higher standard of living
 However, investment often require huge amount of funds, often far beyond the resources
available to a single firm or government.
 In advanced economies, the following occurs:
a. Households
 End up with surplus
 They are "savings surplus units"
 They are net lenders.
 Households, due to their behavior, always need to maximize utility function.
 They want constant & consistent season of benefit
 Long-term investment is not their interest - because the future is uncertain & risky.
 They are interested in short term investments
 They often provide short-term loanable funds, i.e. they land short. Thus, households
always take "Short positions".
b. Sectoral Economies
 Business firms & governments that involve in the production of goods & services
 They make long-term investment in productive (real) assets to increase productivity
 Make expansion, replacement, and/or new investments
 However, the total savings they have often is less than their funds requirement for
investment
 Thus, sectoral economies end up with deficit.
 They are "savings deficit units"
 They become net borrowers
 Borrow long-term funds to make investment
 Thus, sectoral economies always take" long positions"
 Due to the above facts, financial instruments are created in the economy. The savings deficit
units, in this regard, business firms & governments issue (sell) financial claims such as stocks
and bonds to acquire funds, which gives rise to financial liability for the savings deficit units. In
turn, the savings surplus units, often households, provide the surplus funds in their savings in
exchange for the financial claims. This gives rise to financial assets to the savings surplus units.
Therefore, for the households, the increase in the financial assets equals their surplus savings and
for the sectoral units, the increase in the financial liabilities equals their deficit.
 For the economic units
Saving – Investment = Increase in Financial Assets - Increase in Financial liabilities
Net Asset Acquisition = Surplus (for the households) – Deficit (sectoral units)
The final summation of surplus & deficit is Zero for the economy as a whole, i.e. what is surplus
among the net lenders is provided to the savings deficit units, net borrowers. Even if the sum of
surplus & deficit is zero for the economy as a whole, wealth could be created since funds are not
consumed, (i.e. not spent for consumption), currently by the households. Moreover, the financial
instruments - bonds, stocks, deposits, and others do not wear out overtime, usually generate income,

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and normally, their risk of loss is much less than would be true for other forms of stored wealth (like
expenditures on furniture, automobiles, etc).

VII. Features of the transaction

The financial markets operating with in the financial system makes possible the exchange of current
income for future income using financial instruments.
 The savings surpluses units - who supply funds in the financial markets - receive only
promises (financial assets) in return for the loan of their money.
 The savings deficit units - pack the promises in the form of attractive financial claims and
financial services, such as stocks, bonds, deposits, and insurance policies.
Financial claims promise the supplier of funds a future flow of income that may consist of dividends,
interests, capital gains, or other returns. But there is no guarantee that the expected flow of future
income will ever materialize. However, the suppliers of funds to the financial system expect not only
to recover their original commitment of funds but also to earn additional income as a reward for
waiting and for the assumption of risk.

Financial Assets: Role and Property

Broadly speaking, an asset is any possession that has value in an exchange. Assets can be classified as
tangible or intangible. A tangible asset is one whose value depends on particular physical properties—
examples are buildings, land, or machinery. Intangible assets, by contrast, represent legal claims to
some future benefit. Their value bears no relation to the form, physical or otherwise, in which these
claims are recorded. Financial assets are intangible assets which represents legal claims to some future
benefits. It is a claim against the income or wealth of household, business firm and unit of
government. Based on the type of claims, financial assets can be:
1. Debt instruments- For example bonds, notes etc.
2. Equity instruments – For example Common stocks
3. Hybrid instruments- For example Preferred stock and convertible bond

Financial instruments can be classified by the type of claim that the holder has on the issuer. When the
claim is for a fixed dollar/birr amount, the financial instrument is said to be a debt instrument. In
contrast to a debt obligation, an equity instrument obligates the issuer of the financial instrument to
pay the holder an amount based on earnings, if any, after the holders of debt instruments have been
paid. Common stock is an example of an equity claim. A partnership share in a business is another
example.
Some securities fall into both categories in terms of their attributes. Preferred stock, for example, is an
equity instrument that entitles the investor to receive a fixed amount. This payment is contingent,
however, and due only after payments to debt instrument holders are made. Another “combination”
instrument is a convertible bond, which allows the investor to convert debt into equity under certain
circumstances. Both debt instruments and preferred stock that pay fixed dollar amounts are called
fixed-income instruments.
Based upon the market in which financial assets traded in, financial asset can be
1. Money market instruments- short term instruments

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2. Capital market instruments- for long term instruments
3. Hybrid instruments – Both characteristics

Financial instruments exist in an economy because the savings of various individuals, corporations,
and governments differ from investment in real assets.
Characteristics of Financial Assets
Financial Assets do have different characteristics, the following are some these:
 Financial Assets are claims against the income or wealth of a: Household, Business firm, and Unit of
government
 Financial Assets are represented by a certificate, receipt, or other legal document.
 Financial Assets are created by the lending of money (transfer of funds from one unit to another unit)
 Financial Assets do not provide a continuing stream of services to their owners as do the “real assets”
 Financial Assets are promises to future returns to their owners
 Financial Assets serve as a store of value/ purchasing power
 Financial Assets cannot be depreciated or do not wear out
 Their physical condition is not relevant in determining their market value
 They are represented by a piece of paper that serve as a contract
 Financial Assets do have little and/or no value as a commodity
 Financial Assets, relative to their value, do have low (or minimal) transport & storage costs
 Financial Assets are easily transacted & converted in to other form
 Financial Assets are interchanged with or substituted for other assets
Kinds of Financial Assets
The following are basic types (or kinds) of Financial Assets: Money , Equity Security and Debt
Security.
1. Money
 Money represent any financial asset that is accepted in payment for purchase of goods & services
(or in exchanges)
 Examples of Money: Currency, Coins, Cheeks, Plastic Cards, etc
 Money is the most liquid asset among the financial assets.
Money as a Financial Asset
 Money is the most important financial asset
 All financial asset valued interims of money
 Flows occur through the medium of money
 Money itself is a true financial asset; it is a claim against the an entity – institution, public, or
an individual
 Money is basically issued as a debt security
 In an economy that has only few real (productive) assets, goods, and services, excessive money
supply only increases the claim
Examples:
 Checking Accounts – represents debt of commercial bank
 Currency, coin, pocket money- represent claim against resources in the hands of another party
 Some definitions of money include - all forms of debt giving rise to financial assets
 Savings accounts at banks & credit unions
 Shares in money market mutual funds

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 Overnight loans
Functions of Money
The following are some of the functions of money
 Serves as a standard of value - price of goods & services
 Without money, we have to express in exchange ratios
 Money permits us to express the prices in terms of only one measurement unit – monetary unit
 Prices of all goods and services are expressed
 In multiples of monetary unit or
 In fractions of monetary unit
 The only financial asset that all economic units can accept as payment
 It has litter or no use as a commodity
 Acceptable because people knows that they can exchange it at a later date for goods & services
 Monetary unit is separate & is not tied to any particular commodity
 Medium of exchange
 It frees us from the constraints of barter
 It allows us to separate the act of selling from buying
 No need to have an exact coincidence of wants b/n buyers and sellers
 Money need not be converted in order to make an exchange, except in case of foreign
transactions- that still translation require monetary unit denominated in some other currency
 Carry the lowest rate of return
 Cost of holding money- income forgone by not investing
 Measured by rate of interest – price of credit
 Monetary unit translated in to another currency - to find the value it represents in some other
currency
2. Equities (Stocks)
 Stocks or shares are “ownership” securities.
 They are claims against a firm’s profit & proceeds from sale of assets.
3. Debt Securities
 Debt securities are also referred to as IOUs.
 Some of the debt securities are bonds, notes, mortgages, debentures, all other payables, etc
 Legally entitles the holders a priority claim
 Fixed claims in amount & at the time of maturity
 Term of the Indenture (contract) may sometimes require pledges (collaterals)
 Debt securities may be
 Negotiable - transferred from holder to holder
 Non-negotiable - cannot legally be transferred to another party
3.1.3 The Process of Creation of Financial Asset
Assume that
 There are only two economic units existing in an economy - a household and business firm.
 The financial system “Closed” – No external transactions with other units possible
 Each unit holds certain assets that are accumulated over years due to their “Savings”
In this hypothetical situation,

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 Neither party has any outstanding debt
 Each unit is entirely self- financed
 This is due to the fact that assets were acquired by their own savings and spending with in
current income
 Engaged in internal financing – use of current income & accumulated savings to acquire assets
 If the Business firm lacks funds to acquire new assets?
 In this regard, It has four Alternatives. These are:
1. Postpone the acquisition until sufficient internal funds are generated.
2. Sell off exist assets.
3. Borrow a portion of the needed funds (External Financing)
4. Issue new stocks (External Financing)
 If the business firm decides to borrow
 It is entering to external financing
 The Households must provide funds
 The firm should issue securities evidencing a loan of money
 Advantages of borrowing over issuance of stocks
 Helps to raise funds quickly
 Interest is tax deductible
 Effects of leverage
 Favorable (positive) leverage arises
 When earning exceeds the cost of borrowing, it Increases return to owners and EPS
increase or value of stock increase
 However, unfavorable (negative) leverage might also arise
 The firm could issue new equity if the management hesitates to take the advantages on debt
 However, equity financing is
 Much more expensive relative to debt
 Requires more time to arrange
Financial Assets & the Financial System
The “act of borrowing” simultaneously gives rise to the creation of an “equal volume of financial
assets”.
 A financial asset is any asset held by an economic entity that is also recorded as a liability or
claim on some other economic unit.
 Many assets satisfy this definition
 Common & preferred stocks, corporate & government bonds, deposits & loans, etc
 For the entire financial system:
Total Financial Assets = Total Financial Liabilities + Total Claims Outstanding
 Real assets are not necessarily matched by claims or liabilities somewhere in the financial system.
This is because, real assets may be financed partly from Equity, Internal savings and Borrowing
 For the economy as a whole, however, the investment in real assets represent the accumulated
wealth in the society.

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Dep’t of Accounting and Finance Chapter 1 The Role of Financial System in the Economy
 Suppose the following data: You have a saving of birr 10,000, Borrow birr 40,000 and Purchase an
automobile = birr 50,000. Assuming other things remain the same, how much actual wealth do you
think is created in the economy?
To answer this question, we need to see their partial balance sheets shown below:
A Household (Borrower) Lender
Real Assets Liability …. 40,000 Financial Assets Net worth
Birr 50,000 Net worth … 10,000 Birr 40,000 Birr 40,000
Thus, the actual wealth created in the economy amounts to 50,000.
 In light of this, the two equalities which hold for this transaction and also hold whenever
money is loaned & borrowed in the financial system:
1. Volume of Financial Assets created = Volume of liabilities Issued by borrowers
2. Total uses of Funds = Total sources of Funds
 Every financial asset in existence represents the lending or investing of money transferred from
one economic unit to another.
Total Lending = Total Borrowing
For the Balance sheet of any unit in the economy, thus,
Total Assets = Total Liabilities (Claims) + Net worth (Accumulated Savings)
In this regard,
Total Assets = Financial Assets + Real Assets

Thus,
Financial Asset + Real Assets = Total Liabilities + Net Worth
 The aggregate volume of real assets held in the economy must equal the total amount of Net
Worth.
 For the economy & financial system as a whole:
 Total Financial Assets = Total liabilities & Claims
 Total Real Assets = Net Worth (Accumulated Savings in the society)
 Financial Assets and Liabilities (or Claims) cancel each other across the whole financial
system
The foregoing fact implies that:
The value of real assets - buildings, bridges, equipments, etc in existence matches the total amount of
saving carried out by all businesses, households, and units of government. We are no better off in real
terms by the mere creation of financial assets and liabilities. Note that society increases its wealth;
only by saving and investing. Thus, increasing the quantity of real assets through investment in
productive, real tangible, physical facilities.
Lending & Borrowing in the Financial System
An entity may be a lender, a borrower, or both in the economy
 Intermediaries channel the process
 Any economic entity must conform to the following:
Current Expenditure (E) – = Change in Debt Holdings (ΔD) –
Current Income receipt (R) Change in Financial Asset holdings (ΔFA)
That is, E - R = ΔD - ΔFA
Or R - E = ΔFA - ΔD

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Dep’t of Accounting and Finance Chapter 1 The Role of Financial System in the Economy
In this regard, if
E > R → ↓ΔFA or combination ↑ΔD Deficit-Budget unit → E > R; So ΔD > ΔFA
R > E → ↑ΔFA or combination ↓ΔD Surplus-Budget unit → R > E; So ΔFA > ΔD
R = E, then ΔD = ΔFA Balanced-Budget unit → R = E; So ΔD = ΔFA
The financial system enables to adjust economic units their financial position from being a net
borrower to net lender and back again, smoothly and efficiently, through enhancing the lending &
borrowing process.

1.3. Functions Performed by the Financial System and the Financial Markets
There are seven basic functions of the financial system in modern society
1. Saving Function
Financial markets & institutions provides a conduit for the public’s savings. Bonds, stocks, deposits,
and other financial clime sold in the money and capital markets provide a profitable, relatively low-
risk outlet for the public’s savings. The savings flow through the financial markets to the investment
stream so that more goods and services can be produced in the future, increasing society’s standard of
living. When savings flow decline, however, the growth of investment and the living standards tends
to fall. The savings function of any financial system supplies the vital row material of funds to invest
so that economic growth and saving standards can flourish.
2. Wealth Function
For those businesses and individuals choosing to save, the financial instruments sold in the money and
capital markets provide an excellent way to store wealth (i.e. to preserve value or hold purchasing
power) until funds are needed for spending in future periods. While we might choose to store our
wealth in “things”, (e.g. automobiles & clothes), such items are subject to depreciation and often carry
great risk of loss. However, the financial instruments do not wear out overtime, usually generate
income, and normally, their risk, of loss is much less than would be the case in other forms of storing
wealth.
3. Liquidity Function
For wealth that is stored in financial instruments, the financial markets provide a means of converting
those instruments in to ready cash with little risk of loss. The financial system provides liquidity for
savers holding financial instrument but in need of money.
In “Modern societies,” money consists mainly of deposits held in banks. Money is the only financial
instrument possessing perfect liquidity. It can be spent as it is without the necessity of converting it
into some other form. However, Money generally earns the lowest rate of return of all assets traded in
the financial system, and its purchasing power is seriously eroded by inflation. That is why savers
generally minimize their holdings of money and hold bonds & other financial assets until spendable
funds really are needed.
4. Credit Function
The financial markets furnish credit to finance consumption and investment spending (i.e., loan of
funds in return for a promise of suffer payment). Consumers frequently need credit to purchase a
home, other consumable commodities & services, and retire outstanding debt. Businesses draw upon
their lines of credit to stock their shelves, construct buildings, meet payrolls, and grant dividends to

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Dep’t of Accounting and Finance Chapter 1 The Role of Financial System in the Economy
their stockholders. State, local, and federal governments frequently borrow to construct buildings and
other public facilities and cover daily cash expenses until tax revenues flows in. Nowadays, the
volume of credit extended by money and capital markets is huge and growing rapidly due to growth of
the economy, inflation, and the tax deductibility of interest payments as all appear to have resulted in
credit expansion.
5. Payments Function
The financial systems also provide a mechanism for making payments for goods and services. Certain
financial assets, mainly checking accounts and NOW (Negotiable Order of Withdrawal) accounts
serve as a medium of exchange in the making of payments, of course, the latter being common in
advanced economies. Plastic credit cards issued by many banks, credit unions, and retail stores give
the customer instant access to short-term credit. They are widely accepted as a convenient means of
payment. Another type of plastic card – the debit card- is used today to charge a buyer’s deposit
account for purchases of goods and services and transfer the proceeds instantly by wire to the seller’s
account.
6. Risk Function
The financial markets offer businesses, consumers, and government’s protection against life, health,
property, and income risks. This is accomplished by sale of life & property (or casualty) insurance
policies. In addition to making possible the selling of insurance polices, the money & capital markets
have been used increasingly by businesses and consumers to “self insure” against risk. This simply
means building up one’s holdings of securities, deposits, etc, as a precaution against future loss. The
liquidity of most financial instruments makes it easy to rise spend able cash quickly in an emergency.
7. Policy Function
Recently, among the advanced economies, the financial markets have been the principal channel
through which governments carried out the policy of attempting to stabilize the economy and avoid
excessive inflation. By manipulating interest rates and the availability of credit, governments can
affect the borrowing and spending plans of the public. This, in turn, influence the growth of the
economy, opportunities for jobs, increase in production, and the rise in prices of goods & services.
Types of Financial Transactions in the Financial System
Financial system is competitive & continuously changing. This forces participants to respond to public
needs by developing
 New financial services
 Better- quality financial services
 More convenient financial services
The role of all financial systems is to move scarce funds from savers to investors.
Savers (Lenders) → Move funds (Financial System) → Investors (Borrowers)
In general, there are three ways to transfer funds (forms of financial transactions). These are namely:
1. Direct Financing,
2. Semi-Direct Financing, and
3. Indirect Financing
1. Direct Financing
Under this financial transaction
 No market maker involve in channeling the flow of funds
 Simplest form of financing transaction
 Both lender and borrower directly meet each other
 Primary claims are exchanged (provided)

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Limitations
 Both lender and borrower must be willing to exchange the same amount of funds at the same time
 Lender must be willing to accept the borrower’s IOUs (IOU = I Owe You)
 There must exist coincidence of wants
 Both lender and borrower incur substantial information costs
2. Semi-direct Finance
Under this financial transaction
 Security brokers & dealers participate (i.e. financial middlemen involve)
 Bring together the two parties - reduce information cost
 Proceeds from Sale of Security - Broker Fee (Commission Charges)
Limitations
 Ultimate lender still receive primary claim, thus- must be willing to accept the Risk, Liquidity,
and Maturity characteristics of borrower’s IOUs
3. Indirect Finance
Under this financial transactions
 Financial intermediaries involve
 Serve both ultimate lenders & borrowers
 Issue their own- secondary securities – to ultimate lenders
 Accept IOUs – primary claims- from borrowers
The role of Intermediaries in this financial transaction
 Pool resources small savers
 Fulfill credit needs of large firms
 Issue attractive securities – secondary claims
 Satisfy financial needs of both borrowers and lenders
Secondary Claims
 Carry low risk of default
 Can be acquired in small denominations
 Affordable by small savers
 Are liquid
 Convenient with reduced transactions costs

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