Chapte

1
r
Functions and Roles of the Financial
System in the Global Economy

Money and Capital Markets

Financial Institutions and Instruments in a Global Marketplace

Eighth Edition
Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

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 Learning Objectives 

 To understand the functions performed and the

roles played by the system of financial markets
and institutions in the global economy.
 To explore several key terms and concepts of
the money and capital markets.
 To discover how important the financial
system is in increasing our standard of living,
generating new jobs, and building our savings
to meet tomorrow’s financial needs.
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Introduction

 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.
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Introduction

 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.

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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.

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Flows within the Global Economic System

Land and
other natural Flow of production
resources
Goods and
Labor and services sold
managerial to the public
skills
Capital Flow of payments
equipment

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Flows within the Global Economic System

Producing units
(mainly business firms Consuming units
and governments) (mainly households)

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The Role of Markets in the Global Economic System

 In most economies around the world, markets

carry out the complex task of allocating
resources and producing goods and services.
 The marketplace 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.
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Types of Markets

 There are essentially three types of markets

within the global economic system.
 The factor markets allocate the factors of
production to the owners of productive
resources.
 Consuming units use most of their income
from factor markets to purchase goods and
services in product markets.

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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.

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Types of Markets
Product markets F
co low
ns o
nts um f p
me ion Go pt a y m
y od ion e
f pa uct sa a n n ts
w
o r od nd d t for
o p ser ax
Fl of vic es
l ow Financial markets es
F
Flow of funds
Producing units (savings)
(mainly business Consuming units
firms and Flow of financial (mainly households)
governments) services, income, and
financial claims
Pr F l ow es es
od o m ic
uc of in n c r v
tiv c o o f i e se
es
er mes Factor markets F low ctiv
u
vic d
es o
Pr

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The Financial Markets and the Financial System:

Channel for Savings and Investment

 The financial markets make possible the

exchange of current income for future income
and the transformation of savings into
investment so that production, employment,
and income can grow.
 The suppliers of funds to the financial system
can expect not only to recover their original
funds but also to earn additional income as a
reward for waiting and for assuming risk.
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The Global Financial System

Demanders Flow of loanable funds

of funds (savings) Suppliers of
(mainly funds
business (mainly
firms and Flow of financial households)
governments) services, incomes, and
financial claims

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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 public’s 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.
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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.

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Functions Performed by the Global Financial System

and the Financial Markets

 Risk protection function. The financial markets

around the world offer businesses, consumers,
and governments protection against life,
health, property, and income risks.
 Policy function. The financial markets are a
channel through which governments may
attempt to stabilize the economy and avoid
inflation.

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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.
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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.
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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 newly issued
securities are sold in the primary markets.
Security trading in the secondary markets then
provides liquidity for the investors.

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Types of Financial Markets

Within the Global Financial System

 In the spot market, assets or financial services

are traded for immediate delivery (usually
within two business days).
 Contracts calling for the future delivery of
financial instruments are traded in the futures
or forward market.
 Contracts granting the right to buy or sell
certain securities at specified prices within a
certain period are traded in the options market.
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Factors Tying All Financial Markets Together

 Credit, the Common Commodity. The shifting

of borrowers among markets helps to weld the
parts of the global financial system together
and to bring the credit costs in the different
markets into balance with one another.
 Speculation and Arbitrage. Speculators who
watch for profitable arbitrage opportunities
help to maintain consistent prices among the
markets.
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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.
 In the real world however, market
imperfection and information asymmetry exist.

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The Dynamic Financial System

 The global financial system is rapidly

changing.
 In particular, there are trends toward the
deregulation of financial institutions and
services, the harmonization of regulations, and
global integration, leading to more intense
competition as well as the development of new
financial services.

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The Plan of This Book

 Part One provides an overview of the global

financial system – its role in the world’s
economy and its 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).
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The Plan of This Book

 Part Four gives a closer look at commercial

banks, credit unions, savings and loan
associations, money market funds, insurance
companies, pension funds, mutual funds, and
other financial-service firms.
 Part Five turns to the role of governments –
federal, state, and local – within the global
financial system.

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The Plan of This Book

 Part Six focuses on the financial activities of

nonfinancial business firms and consumers.
 Part Seven is devoted to the international
financial system and future trends in global
finance.

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Money and Capital Markets in Cyberspace

 For more on the nature of the financial system,

see http://homepages.uel.ac.uk
/K.Bain/fimac223.html.
 Help on planning for savings and investments
is available at http://www.sec.gov/investor.shtml.
 How much wealth does the U.S. really have
and how unevenly is it distributed? See
http://www.aei.org/research/description.htm#1.113
and http://woodrow.mpls.frb.fed.us/research/.
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Money and Capital Markets in Cyberspace

 For a discussion of the important roles

performed by capital markets within the
financial system, see http://www1.worldbank
.org/finance/.
 For further discussion on the low U.S. savings
rate, see http://www.bankrate.com/brm/.
 For a discussion of the concept of arbitrage,
see http://www.finpipe.com/derivglossary.htm.

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Money and Capital Markets in Cyberspace

 Some experts see the Internet as a nearly

perfect market. See, for example, http://www.
wright.edu/~tdung/internet.htm.

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Chapter Review

 Introduction
 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  2003 by The McGraw-Hill Companies, Inc. All rights reserved.
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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

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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

 Factors Tying All Financial Markets Together

 The Dynamic Financial System

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 1 - 33

Chapter Review

 The Plan of This Book

McGraw Hill / Irwin  2003 by The McGraw-Hill Companies, Inc. All rights reserved.