Chapter One

The Role of the financial System in the

Economy

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 1.1.The Economy and the Financial System
 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 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)

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 Cont’d
 The financial system of nations might be either
bank based financial system or market based
financial system.
The financial system determines:
1. The cost of credit, and
2. How much credit will be available to pay for
goods/services

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 Cont’d
 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.

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 Cont’d
 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

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 Cont’d
 The impacts of financial operations in the economic
system, there are two fundamental scenarios (arguments).
 These are;
a) Money Expansion Scenario and
b) The Liquidity (Keynesian) Scenario.
 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.

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 Cont’d
 Money Expansion Scenario, increases in
financial operations increases spending in the
society, which, in turn, increases the
investment activity in the same.

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 /

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 The role of market in the economic system
 A market is an institution setup by society to allocate
resources that are scarce relative to the demand for them.
 A channel through which buyers & sellers meet to
exchange goods, service & resource.
Type of Markets
 There are essentially three types of markets at work with
in the economic system
1. Factors markets,
2. Product markets, and
3. Financial markets
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 1. Factor market
 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.
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 2. product market
 Food, shelter, automobiles, etc. are among the
many goods and services sold in the product
markets.

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 3.Financial markets
 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.
 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.

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 Cont’d
Financial market, therefore,
 Attract excess savings
 Determine volume of credit available
 Determine interest rates & security price in
the economy.

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 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.

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 Cont’d
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 revenues over
expenditures.

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 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".

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 Sectoral units
 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"
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 Cont’d
 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.
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 Cont’d

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 End of Chapter One

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