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Chapter 1. Functions and Roles of the Financial System in the Global Economy. Slides by Yee-Tien (Ted) Fu. To 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.

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Chapter 1

Chapter 1

Functions and Roles of the Financial System in the Global Economy

Slides by Yee-Tien (Ted) Fu


Learning objectives

To 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.

To 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.

 Learning Objectives 


Introduction to the financial system

The financial system is …

Introduction to the Financial System

  • 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.


Introduction to the financial system1

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.

Introduction to the Financial System


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.

Flows within the Global Economic System


Circular flow of income payments and production in the global economic system

Flow of productive services

Flow of expenditures for consumption & taxes

Flow of production of goods & services

Flow of incomes

Producing units (mainly business firms and governments)

Consuming units (mainly households)

Circular Flow of Income, Payments, and Productionin the Global Economic System


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.

The Role of Markets in the Global Economic System


Types of markets

There are essentially three types of markets within the global economic system.

The factor markets allocate factors of production (land, labor, skills, capital) and distribute income (wages, rent) to the owners of productive resources.

Consuming units use most of their income from factor markets to purchase goods and services in the product markets.

Types of Markets


Types of markets1

The financial markets channel savings to those individuals and institutions needing more funds for spending than are provided by their current incomes.

Types of Markets


Types of markets2

Product markets

Flow of payments for

consumption and taxes

Flow of payments

Flow of production

Goods and services

Financial markets

Flow of funds (savings)

Flow of financial services, income, and financial claims

Producing units (mainly business firms and governments)

Consuming units (mainly households)

Flow of incomes

Flow of incomes

Productive services

Productive services

Factor markets

Types of Markets


The 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

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


The financial markets and the financial system channel for savings and investment1

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 can 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.

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


The global financial system

Demanders of funds (mainly business firms and governments)

Flow of loanable funds (savings)

Suppliers of funds (mainly households)

Flow of financial services, incomes, and financial claims

The Global Financial System


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.

Functions Performed by the Global Financial System and the Financial Markets


Functions performed by the global financial system and the financial markets1

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, in the form of currency, checking accounts, debit cards, credit cards, digital cash, etc.

Functions Performed by the Global Financial System and the Financial Markets


Functions performed by the global financial system and the financial markets2

Risk protection function. The financial markets offer protection against life, health, property, and income risks, by permitting individuals and institutions to engage in both risk-sharing and risk reduction.

Policy function. The financial markets are a channel through which governments may attempt to stabilize the economy and avoid inflation.

Functions Performed by the Global Financial System and the Financial Markets


Functions performed by the global financial system and the financial markets3

The financial services that are most widely sought by the public include:

Payments services

Thrift services

Insurance services

Credit services

Hedging services

Agency services

Functions Performed by the Global Financial System and the Financial Markets


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.

Types of Financial MarketsWithin the Global Financial System


Types of financial markets within the global financial system1

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.

Types of Financial MarketsWithin the Global Financial System


Types of financial markets within the global financial system2

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

Types of Financial MarketsWithin the Global Financial System


Types of financial markets within the global financial system3

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 of financial instruments.

Options markets enable contracts that grant the right to buy or sell certain securities at specific prices within a certain time to be traded.

Types of Financial MarketsWithin the Global Financial System


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.

Factors Tying All Financial Markets Together


Factors tying all financial markets together1

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.

Financial markets in the real world. In the real world however, market imperfection and information asymmetry exist.

Factors Tying All Financial Markets Together


The dynamic financial system

The global financial system is rapidly changing.

In particular, the trend towards the global integration of financial systems has been aided by the gradual deregulation of financial institutions and services as well as the increasing harmonization of their regulations.

The Dynamic Financial System


The dynamic financial system1

The results have been increasingly intense competition, many new financial services, increased risk, and a wave of mergers among financial institutions.

The Dynamic Financial System


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 and its principal instruments and institutions (including the central bank).

The Plan of This Book


The plan of this book1

Part Four takes a closer look at commercial banks, credit unions, savings and loan 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.

The Plan of This Book


The plan of this book2

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.

The Plan of This Book


Markets on the net

Bankrate.com at www.bankrate.com/brm

Chicago Board of Trade at www.cbot.com

Derivatives Concepts A-Z at www.finpipe.com/derivglossary.htm

Moody’s Investor Service at www.moodys.com

Securities and Exchange Commission at www.sec.gov

Markets on the Net


Markets on the net1

Standard and Poor’s Corporation at www.standardandpoors.com

The Financial Times at www.ftbusiness.com

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

Markets on the Net


Markets on the net2

U.S. Treasury Department at www.publicdebt.treas.gov

Markets on the Net


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

Chapter Review


Chapter review1

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

Chapter Review


Chapter review2

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

Chapter Review


Chapter review3

Factors Tying All Financial Markets Together

Credit, the Common Commodity

Speculation and Arbitrage

Perfect and Efficient Markets

Financial Markets in the Real World: Imperfection and Asymmetry

The Dynamic Financial System

The Plan of This Book

Chapter Review


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