The Financial SystemThe Financial System

A collection of markets, A collection of markets, institutionsinstitutions, , laws, regulations, and techniqueslaws, regulations, and techniques

Bonds, stocks, and other securities are Bonds, stocks, and other securities are tradedtraded

Interest rates are determinedInterest rates are determinedFinancial services are produced Financial services are produced Financial services are delivered around Financial services are delivered around

the worldthe world

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The Primary Task of the Financial SystemThe Primary Task of the Financial System

It moves scarce loanable funds. It moves scarce loanable funds. Funds are shifted from those who save. Funds are shifted from those who save. The funds are moved to those who The funds are moved to those who

borrow to buy goods and services and borrow to buy goods and services and to make investments in new equipment to make investments in new equipment and facilities.and facilities.

That movement enables the global That movement enables the global economy to grow and the standard of economy to grow and the standard of living to increase.living to increase.

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Flows within the Global Flows within the Global Economics SystemEconomics System

Basic function of the Basic function of the economic systemeconomic system Allocate scarce resources; land, labor, Allocate scarce resources; land, labor,

management skill, and capitalmanagement skill, and capital Produce the goods and services needed by Produce the goods and services needed by

societysocietyThe global economy generates a flow of The global economy generates a flow of

production in return for a flow of production in return for a flow of paymentspayments

The circular flow of production and The circular flow of production and income is interdependentincome is interdependent

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Circular Flow of Income, Payments, and Circular Flow of Income, Payments, and Production in the Global Economic SystemProduction in the Global Economic System

Producing units (mainly businesses and

governments)Consuming units

(mainly households)

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The Role of Markets The Role of Markets in the Global Economic Systemin the Global Economic System

Most economies around the world rely Most economies around the world rely principally upon principally upon marketsmarkets to carry out to carry out the complex task of allocating scarce the complex task of allocating scarce resources.resources.

The marketplace is The marketplace is dynamicdynamic. It . It determines what goods and services determines what goods and services will be produced and in what quantities will be produced and in what quantities through their through their pricesprices..

Markets also distribute Markets also distribute incomeincome by by rewarding superior producers with rewarding superior producers with increased profits, higher wages, and increased profits, higher wages, and other economic benefits.other economic benefits.

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Three Types of MarketsThree Types of Markets

The The factor marketsfactor markets Allocate factors of production (land, labor, Allocate factors of production (land, labor,

skills, capital)skills, capital) Distribute income (wages, rent) to the Distribute income (wages, rent) to the

owners of productive resourcesowners of productive resources TheThe product markets product markets

Allocate goods and servicesAllocate goods and services Consuming units use most of their income Consuming units use most of their income

in this marketin this market 1-6

Three Types of MarketsThree Types of Markets

The The financial marketsfinancial markets Allocate savings to individuals and Allocate savings to individuals and

institutionsinstitutions Those that need more funds for spending Those that need more funds for spending

than are provided by their current incomesthan are provided by their current incomes

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Types of MarketsTypes of Markets

Producing units (mainly businesses and governments)

Consuming units (mainly households)

Flow of funds (savings)

Flow of financial services, income, and

financial claims

Financial marketsFlow of p

roduction

Product markets

Goods and servicesFlow of p

aymentsFlow of payments for

consumption and taxes

Flow of incomesFlow of incomes Factor markets

Productive se

rvicesProductive services

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Financial Markets and the Financial System: Financial Markets and the Financial System: Channel for Savings and InvestmentChannel for Savings and Investment

Nature of savingsNature of savings Households: current income – tax Households: current income – tax

payments – consumption expenditurespayments – consumption expenditures Businesses: retained earningsBusinesses: retained earnings Governments: current revenues – Governments: current revenues –

expendituresexpendituresNature of investmentNature of investment

Households: purchase of a homeHouseholds: purchase of a home Businesses: expenditures on capital goods Businesses: expenditures on capital goods

and inventoriesand inventories Governments: building/maintaining public Governments: building/maintaining public

facilitiesfacilities1-9

Financial Markets and the Financial System: Financial Markets and the Financial System: Channel for Savings and InvestmentChannel for Savings and Investment

The financial markets enable the The financial markets enable the exchange of current income for future exchange of current income for future incomeincome and the and the transformation of transformation of savings into investmentsavings into investment so that so that production, employment, and income production, employment, and income can grow, and living standards improve.can grow, and living standards improve.

The suppliers of funds to the financial The suppliers of funds to the financial system expect not only to recover their system expect not only to recover their original funds but also to earn additional original funds but also to earn additional income as a reward for waiting and income as a reward for waiting and assuming risk.assuming risk.

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The Global Financial SystemThe Global Financial System

Flow of financial services, incomes, and

financial claims

Demanders of funds (mainly

businesses and

governments)

Flow of loanable funds (savings) Suppliers of

funds (mainly

households)

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

Provides a channel for the public’s Provides a channel for the public’s savingssavings Profitable outlet for utilization of savingsProfitable outlet for utilization of savings Relatively low-riskRelatively low-risk

Savings flow through the financial Savings flow through the financial markets to investments allowing the markets to investments allowing the economy to increase productioneconomy to increase production

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

Wealth is the value of accumulated Wealth is the value of accumulated savings built up over timesavings built up over time Financial instruments provide an excellent Financial instruments provide an excellent

way to store wealthway to store wealth Financial instruments do not depreciate and Financial instruments do not depreciate and

often generate incomeoften generate income Financial instruments have less risk than Financial instruments have less risk than

many other forms of wealth storingmany other forms of wealth storing

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

Provide liquidity for savers who hold Provide liquidity for savers who hold financial instruments but are in need of financial instruments but are in need of moneymoney

Money is mainly currency and deposits Money is mainly currency and deposits held in depository institutionsheld in depository institutions Can be spent without need of conversionCan be spent without need of conversion Earns the lowest rate of return of all Earns the lowest rate of return of all

financial assetsfinancial assets

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

A mechanism for making payments for A mechanism for making payments for purchases of goods and servicespurchases of goods and services Certain financial assets have been popular Certain financial assets have been popular

means of exchange (currency, demand means of exchange (currency, demand deposits, etc.)deposits, etc.)

Growing in popularity are debit and credit Growing in popularity are debit and credit cardscards

Many other instruments are also growing in Many other instruments are also growing in popularity (ATM cards etc.)popularity (ATM cards etc.)

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Function Performed by the Global Financial Function Performed by the Global Financial System: Risk ProtectionSystem: Risk Protection

The financial markets offer protection The financial markets offer protection against life, health, property, and against life, health, property, and income risksincome risks

Permits individuals and institutionsPermits individuals and institutionsEngage in Engage in risk-sharingrisk-sharing Engage in Engage in risk reductionrisk reduction

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Function Performed by the Global Financial Function Performed by the Global Financial System and the Financial Markets: CreditSystem and the Financial Markets: Credit

Furnish credit to finance current Furnish credit to finance current consumption and investment spendingconsumption and investment spending

Policy Function:Policy Function:A channel through which governments A channel through which governments

may attempt to influence the economymay attempt to influence the economyThe task of economic stabilization has The task of economic stabilization has

been given largely to central banksbeen given largely to central banks

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Types of Financial MarketsTypes of Financial MarketsWithin the Global Financial SystemWithin the Global Financial System

The The money marketmoney market is the market for short- is the market for short-term (one year or less) loans. term (one year or less) loans.

The The capital marketcapital market finances long-term finances long-term investments by businesses, governments, investments by businesses, governments, and households.and households.

In particular, governments borrow from In particular, governments borrow from commercial banks in the money market, while commercial banks in the money market, while in the capital market, insurance companies, in the capital market, insurance companies, mutual funds, security dealers, and pension mutual funds, security dealers, and pension funds supply the funds for businesses.funds supply the funds for businesses.

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Types of Financial MarketsTypes of Financial MarketsWithin the Global Financial Within the Global Financial

SystemSystem In In open marketsopen markets, financial instruments are , financial instruments are

sold to the highest bidder, and can be traded sold to the highest bidder, and can be traded as often as is desirable before maturity.as often as is desirable before maturity.

In In negotiated marketsnegotiated markets, the instruments are , the instruments are sold to one or a few buyers under private sold to one or a few buyers under private contract.contract.

Financial capital is raised when new Financial capital is raised when new securities are sold in the securities are sold in the primary marketsprimary markets. .

Security trading in the Security trading in the secondary marketssecondary markets then provides liquidity for the investors.then provides liquidity for the investors.

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Exchanges and Over the counter (OTC) Exchanges and Over the counter (OTC) marketsmarkets

In In exchanges exchanges buyers and sellers of buyers and sellers of securities meet in one central location to securities meet in one central location to conduct trades. Whereas in conduct trades. Whereas in Over the Over the counter (OTC) counter (OTC) markets buyers and markets buyers and sellers are at different locations and are sellers are at different locations and are willing to buy or sell securities OTC to willing to buy or sell securities OTC to anyone who comes to them and willing anyone who comes to them and willing to accept their price e.g. NASDAQ.to accept their price e.g. NASDAQ.

Types of Financial MarketsTypes of Financial MarketsWithin the Global Financial SystemWithin the Global Financial System

In the In the spot marketspot market, assets or financial services are , assets or financial services are traded for immediate delivery (usually within two traded for immediate delivery (usually within two business days).business days).

Contracts calling for the future delivery of Contracts calling for the future delivery of financial instruments are traded in the financial instruments are traded in the futuresfutures or or forward marketforward market..

Contracts granting the right to buy or sell certain Contracts granting the right to buy or sell certain securities at specified prices within a certain period securities at specified prices within a certain period are traded in the are traded in the options marketoptions market..

Factors Tying All Financial Factors Tying All Financial Markets TogetherMarkets Together

Credit, the common commodity.Credit, the common commodity. The The shifting of borrowers among markets shifting of borrowers among markets helps to weld the financial system helps to weld the financial system together and to balance the costs of together and to balance the costs of credit in the different markets.credit in the different markets.

Speculation and arbitrage.Speculation and arbitrage. Speculators Speculators who gamble on their market forecasts who gamble on their market forecasts and arbitrageurs who watch for and arbitrageurs who watch for profitable arbitrage opportunities help profitable arbitrage opportunities help to level out prices and maintain price to level out prices and maintain price consistency among the markets.consistency among the markets.

The Dynamic Financial SystemThe Dynamic Financial SystemThe global financial system rapidly The global financial system rapidly

changing into a new systemchanging into a new systemThe trend toward global integration of The trend toward global integration of

financial systemsfinancial systems Powered by innovations as new financial Powered by innovations as new financial

services and instruments continually services and instruments continually appear to attract customersappear to attract customers

Benefiting from increasing harmonization of Benefiting from increasing harmonization of regulationsregulations

The Dynamic Financial SystemThe Dynamic Financial System

The results are major changes to the The results are major changes to the marketmarket Increasingly intense competition Increasingly intense competition Many new financial servicesMany new financial services Increased riskIncreased risk A wave of mergers among financial A wave of mergers among financial

institutionsinstitutions

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