Chapter 1

Functions and Roles of the

Financial System in the
Global Economy
McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies,

 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
tomorrows 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
governments)

Consuming units
(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

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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
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Producing units
(mainly businesses
and governments)
Pr Flow
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uc of in
tiv
e s c om
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vic s
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Financial markets
Flow of funds
(savings)
Flow of financial
services, income, and
financial claims

Factor markets

F
co low
ns o
u f
Go mp pay
od tion me
n
sa
nd and ts fo
ser tax r
vic es
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Consuming units
(mainly households)
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ow cti
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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
of funds
(mainly
businesses
and
governments)

Flow of loanable funds

(savings)
Flow of financial
services, incomes, and
financial claims

Suppliers of
funds
(mainly
households)

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Function Performed by the Global Financial

System and the Financial Markets: Savings

Provides a conduit for the publics

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 shortterm (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
worlds 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
1-36

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
Moodys 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 Poors 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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