Chapter 1

Functions and Roles of the

Financial System in the
Global Economy

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
  Learning Objectives 

 You will 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.
 You will 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.
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 The Financial System

 A collection of markets, institutions,

laws, regulations, and techniques
 Bonds, stocks, and other securities are
traded
 Interest rates are determined
 Financial services are produced
 Financial services are delivered around
the world

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 The Primary Task of the Financial System

 It moves scarce loanable funds.

 Funds are shifted from those who save.
 The funds are moved to those who
borrow to buy goods and services and
to make investments in new equipment
and facilities.
 That movement enables the global
economy to grow and the standard of
living to increase.
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 Flows within the Global
Economics System
 Basic function of the economic system
 Allocate scarce resources; land, labor,
management skill, and capital
 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
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 Circular Flow of Income, Payments, and
Production in the Global Economic System

Producing units
(mainly businesses and Consuming units
governments) (mainly households)

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 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.
 The marketplace is dynamic. It
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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 Three Types of Markets

 The factor markets

 Allocate factors of production (land, labor,
skills, capital)
 Distribute income (wages, rent) to the
owners of productive resources
 The product markets
 Allocate goods and services
 Consuming units use most of their income
in this market
 1-9
 Three Types of Markets

 The financial markets

 Allocate savings to individuals and
institutions
 Those that need 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
e Go pt aym
a y m
t ion od ion e
p c sa an nts
of rodu nd d t fo r
low f p ser ax
F o vic es
o w Financial markets es
Fl
Flow of funds
Producing units (savings)
(mainly businesses Consuming units
and governments) Flow of financial (mainly households)
services, income, and
financial claims
Pr Flow e s
m ices
od o
uc of in in c
e r v
tiv of ve s
e s co m
er e Factor markets lo w cti
vic s F du
es o
Pr
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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
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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, employment, and income
can grow, and living standards improve.
 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.
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 The Global Financial System

Demanders Flow of loanable funds

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

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Function Performed by the Global Financial
System and the Financial Markets: Savings

 Provides a conduit for the public’s

savings
 Profitable outlet for utilization of savings
 Relatively low-risk
 Savings flow through the financial
markets to investments allowing the
economy to increase production

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Function Performed by the Global Financial
System and the Financial Markets: Wealth

 Wealth is the value of accumulated

savings built up over time
 Financial instruments provide an excellent
way to store wealth
 Financial instruments do not depreciate and
often generate income
 Financial instruments have less risk than
many other forms of wealth storing

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Function Performed by the Global Financial
System and the Financial Markets: Wealth

 Financial wealth is extensive

 $55 trillion in US financial assets held by
domestic nonfinancial businesses
 $11 trillion in US financial assets held by
international investors

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 Example
Wealth from prior period $1000
Savings from this period $50
Rate of return on wealth 10%

Return =0.10*($1000) = $100

Wealth at the end of the period

$1000+$50+$100 = $1150

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Function Performed by the Global Financial
System and the Financial Markets: Liquidity

 Provide liquidity for savers who hold

financial instruments but are in need of
money
 Money is mainly currency and deposits
held in depository institutions
 Can be spent without need of conversion
 Earns the lowest rate of return of all
financial assets

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Function Performed by the Global Financial
System and the Financial Markets: Credit
 Furnish credit to finance current
consumption and investment spending
 Accessed by pledging future income
 The flipside of savings
 Volume of credit in the United States is
huge and growing
 Total credit funds raised in the US in 2005 is
$3.4 trillion
 More than double what it was a decade
before

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Function Performed by the Global Financial
System and the Financial Markets: Payment

 A mechanism for making payments for

purchases of goods and services
 Certain financial assets have been popular
means of exchange (currency, demand
deposits, etc.)
 Growing in popularity are debit and credit
cards
 Many other instruments are also growing in
popularity (ATM, Stored-value cards, etc.)

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Function Performed by the Global Financial
System: Risk Protection

 The financial markets offer protection

against life, health, property, and
income risks
 Permits individuals and institutions
 Engage in risk-sharing
 Engage in risk reduction

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Function Performed by the Global Financial
System and the Financial Markets: Policy

 A channel through which governments

may attempt to influence the economy
 Affect borrowing and spending plans
 Impact the growth rates of jobs, production,
and prices
 The task of economic stabilization has
been given largely to central banks

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 Functions Performed by the Global
Financial System and the Financial Markets

 There are many financial services that

are widely sought after
 Payments services
 Thrift services
 Insurance services
 Credit services
 Hedging services
 Agency services

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 Types of Financial Markets
Within the Global Financial System

 The money market is the market for short-

term (one year or less) loans.
 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
 Treasury bills
 Certificates of deposit (CDs)
 Bankers’ acceptances
 Commercial paper
 Federal funds
 Eurocurrencies

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 Types of Financial Markets
Within the Global Financial System
 The capital market may be subdivided
 Mortgage loans
 Tax-exempt (municipal) bonds
 Consumer loans
 Eurobonds and Euronotes
 Corporate stock
 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 can be traded
as often as is desirable before maturity.
 In negotiated markets, the instruments are
sold to one or a few buyers under private
contract.
 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.

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 Three Types of Financial Markets

 In the spot market, 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.
 Options markets enable contracts that
grant the right to buy or sell certain
securities at specific prices within a
certain time.

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 Factors Tying All Financial
Markets Together
 Credit, the common commodity. The
shifting of borrowers among markets
helps to weld the financial system
together and to balance the costs of
credit in the different markets.
 Speculation and arbitrage. 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.
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 The Dynamic Financial System
 The global financial system rapidly
changing into a new system
 The trend toward global integration of
financial systems
 Powered by innovations as new financial
services and instruments continually
appear to attract customers
 Non-financial companies invading the
financial services field
 Aided by the gradual deregulation
 Benefiting from increasing harmonization of
regulations
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 The Dynamic Financial System

 The results are major changes to the

market
 Increasingly intense competition
 Many new financial services
 Increased risk
 A wave of mergers among financial
institutions

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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 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, its principal institutions
and instruments, and to central banks

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 The Plan of This Book
 Part Four takes a closer look at
commercial banks, credit unions,
savings associations, money market
funds, insurance companies, pension
funds, mutual funds, and other private
financial-service firms.
 Part Five turns to the role of
governments (federal, state, and local)
and business firms within the global
financial system.

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 The Plan of This Book

 Part Six focuses on the financial

characteristics of consumers –
individuals and families.
 Part Seven is devoted to the
international financial system and future
trends in global finance.

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 Markets on the Net

 AOL Money and Finance at

money.aol.com
 Bankrate.com at
www.bankrate.com/brm
 Bloomberg at Bloomberg. COM
 Chicago Board of Trade at
www.cbot.com
 CNN Money at money.cnn.com/markets

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 Markets on the Net
 Derivatives Concepts A-Z at
www.finpipe.com/derivglossary.htm
 Federal Reserve of San Francisco
frbsf.org
 Finance Center at money.aol.com
 Forbes at forbes.com
 Kiplinger at kiplinger.com
 Moody’s Investor Service at
www.moodys.com
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 Markets on the Net
 Reuters at moneyline.com
 Securities and Exchange Commission at
www.sec.gov
 Smartmoney at smartmoney.com
 Standard and Poor’s Corporation at
www.standardandpoors.com
 The Economist at econo`mist.com
 The Financial Times at
www.ftbusiness.com
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 Markets on the Net

 The Wall Street Journal at www.wsj.com

 U.S. Bureau of Economic Analysis at
www.bea.gov
 U.S. Bureau of the Census at
www.census.gov
 U.S. Treasury Department at
www.publicdebt.treas.gov
 Yahoo Finance at finance.yahoo.com

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 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
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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

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 Chapter Review

 Factors tying all financial markets

together
 Credit, the common commodity
 Speculation and arbitrage
 The dynamic financial system
 The plan of this book

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