Chapter 1

Functions and Roles of the Financial System in the Global Economy

1.1 Introduction to the Financial System

The financial system is one of the most important creations of modern society. It's primary task
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 increase the standard of living enjoyed by its citizens. Without the global financial
system and the loanable funds it supplies, each of us would lead a much less enjoyable existence.
The financial system determines both the cost and the quantity of funds available in the economy
to pay for the thousands of goods and services we purchase daily. This system has a powerful
impact upon the health of the global economy when funds become more costly and less
available, spending for goods and services falls. As a result, unemployment rises and the
economys growth slows and lay off workers. In contrast, when the cost of funds declines and
loanable funds become more readily available, spending in the economy often increases, more
jobs are created, and the economys growth accelerates. In truth, the global financial system is an
integral part of the global economic system. We cannot understand one of these systems without
understanding the other.

1.2 The Global Economy and the Financial System

Flows within the Global Economic System

The basic function of the global economic system is to allocate scarce resources—land, labor,
management skill, and capital—to their most highly valued use, producing the goods and
services needed by society. The high standard of living most of us enjoy today depends on the
ability of the global economy to turn out each day an enormous volume of food, shelter, and
other essentials of modern living. This is an exceedingly complex task because scarce resources
must be procured in just the right amounts to provide the raw materials of production and
combined at just the right time with labor, management, and capital to generate the products and
services demanded by consumers. In short, any economic system must combine inputs—land
and other natural resources, labor and management skill, and capital equipment—to produce
output—goods and services.

The global economy generates a flow of production in return for a flow of payments. We can
depict the flows of payments and production within the global economic system as a circular
flow between producing units (mainly businesses and governments) and consuming units
(principally households).(See Figure 1.1.) In the modern economy, households provide labor,
management skill, and natural resources to business firms and governments in return for income
in the form of wages, salaries, and other payments. The circular flow of production and income
is interdependent and never ending.

Figure 1.1 Circular Flow of Income, Payments, and Production in the Global Economic System

The Role of Markets in the Global Economic System

Market is an institution through which buyers and sellers meet to exchange goods, services, and
productive resources. This exchange determines what goods and services will be produced and in
what quantity. The marketplace is dynamic. It must respond continuously not only to changes in
consumers tastes, but also to the introduction of new goods and services, often associated with
new technology. Today, cell phones and DVDs are part of our everyday lives, yet they barely
existed a few years ago.

• The resources of the economy got redeployed to produce those new goods. This shift in
production was accomplished in the marketplace through changes in the prices of goods and
services being offered. If the price of an item rises, for example, this stimulates business firms to
produce and supply more of it to consumers. In the long run, new firms may enter the market to
produce those goods and services experiencing increased demand and rising prices. A decline in
price, on the other hand, usually leads to reduced production of a good or service, and in the long
run some less-efficient suppliers may leave the marketplace.

• Markets also distribute income. In a pure market system, the income of an individual or a
business firm is determined solely by the contribution each makes to producing goods and
services demanded by the marketplace.
• Markets reward superior productivity and sensitivity to consumer demands with increased
profits, higher wages, and other economic benefits. Of course, in all economies, government
policies also affect the distribution of income and the allocation of other economic benefits.

Types of Markets

There are essentially three types of markets at work within the global economic system: (1)
factor markets, (2) product markets, and (3) financial markets (see Figure 1.2 ).

• In factor markets, consuming units sell their labor and other resources to those producing units
offering the highest prices. The factor markets allocate factors of production—land, labor,
managerial skills, and capital—and distribute income—wages, salaries, rental payments, and so
on—to the owners of productive resources.

• Consuming units use most of their income from factor markets to purchase goods and services
in product markets. Food, shelter, automobiles, theater tickets, and clothing are among the many
goods and services sold in product markets.

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

Figure 1.2 Three Types of Markets in the Global Economic System

The Financial Markets and the Financial System:

Channel for Savings and Investment

The financial market, performs a vital function within the global economic system. The financial
markets channel savings to those individuals and institutions need more funds for spending than
are provided by their current incomes. The financial markets are the heart of the global financial
system, attracting and allocating savings and setting interest rates and the prices of financial
assets (stocks, bonds, etc.).

Nature of Savings The definition of savings differs depending on what type of unit in the
economy is doing the saving.

• For households, savings are what is left from current income after current consumption
expenditures and tax payments are made.

• In the business sector, savings include current earnings retained inside business firms after
payment of taxes, stockholder dividends, and other cash expenses.

• Government savings arise when there is a surplus of current revenues over current expenditures
in a governments budget.

Nature of Investment Most of the funds set aside as savings flow through the global financial
markets to support investment by business firms, governments, and households. Investment
generally refers to the acquisition of capital goods, such as buildings and equipment, and the
purchase of inventories of raw materials and goods to sell. The makeup of investment varies with
the particular unit doing the investing.

• For a business firm, expenditures on capital goods (fixed assets, such as buildings and
equipment) and inventories (consisting of raw materials and goods offered for sale) are
investment expenditures.

• In contrast to businesses, for households, current accounting procedures in the United States
stipulate that only the purchase of a home may be counted as an investment. All other household
expenditures on durable goods (such as autos and furniture), as well as expenditures on
nondurable goods (for exam_ple, food and fuel) and services (such as having your hair styled)
are lumped together as consumption spending (i.e., expenditures on current account), rather than
investment spending.

• Government spending to build and maintain public facilities (such as buildings, monuments,
and highways) is another form of investment. Modern economies require enormous amounts of
investment to produce the goods and services demanded by consumers.

Investment increases the productivity of labor and leads to a higher standard of living. However,
investment often requires huge amounts of funds, far beyond the resources available to a single
individual or institution. By selling financial claims (such as stocks and bonds) in the financial
markets, large amounts of funds can be raised quickly from the pool of savings accumulated by
households, businesses, and governments. The unit carrying out the investment then hopes to
repay its loans from the financial marketplace by generating future income. Indeed, the money
and capital markets make possible 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 role of the financial markets in channeling savings into investment is absolutely essential to
the health of the economy. Indeed, countries with better-developed financial systems tend to
grow faster.

Those who supply funds to the financial markets receive only promises in return for the loan of
their money. These promises are packaged in the form of attractive financial claims and financial
services, such as stocks, bonds, deposits, and insurance policies (see Figure1.3). Financial claims
promise the supplier of funds a future flow of income in the form of dividends, interest, or other
returns. But there is no guarantee that the expected income will ever materialize. However,
suppliers of funds to the financial system expect not only to recover their original funds but also
to earn addi_tional income as a reward for waiting and for assuming risk.

Figure
1.3 The Global Financial System

1.3 Economic Functions Performed by the Global Financial System and the
Financial Markets
The great importance of the financial system in our daily lives can be illustrated by reviewing the
different functions that it performs. The global financial system has seven basic economic
functions that create a need for the money and capital markets.
1.Savings Function The global system of financial markets and institutions provides a conduit
for the publics savings. Bonds, stocks, and other financial claims sold in the money and capital
markets provide a profitable, relatively low-risk outlet for the publics savings. By acquiring these
financial assets, households may choose to forego consumption today in order to increase their
consumption opportunities in the future.

In the process, this flow of savings through the financial markets into investment allows the
economy to increase production while raising productivity, thereby increasing the worlds
standard of living. In contrast, when savings decline, investment and living standards begin to
fall in those nations where savings are in short supply.

2.Wealth Function • For any individual, business firm, or government, wealth is the sum of the
values of all assets we hold at any point in time. Thus, our wealth at the moment equals the
combined value of the automobiles, homes, clothing, and hundreds or thousands of other assets
we have managed to accumulate and hold up to the present day.

Our wealth is built up over time by a combination of current savings plus income earned from all
our previously accumulated wealth. The increase (or decrease) in the total wealth we own in the
current time period equals our current savings plus the value of all previously accumulated
wealth multiplied by the average rate of return on all previously accumulated wealth.

For example, suppose our wealth (accumulated assets) at the end of the previous period was
$1,000. In the current time period we manage to save an additional $50 and also earn an average
rate of return on our previously accumulated wealth of 10 percent or $100 (that is, $1,000
multiply by 0.10). Then our wealth will increase from $1,000 in the previous period to $1,150 in
the current period (that is, $1,000 + $50 + $100).

• The portion of wealth held by society in the form of stocks, bonds, and other financial assets—
that is, financial wealth —is created by the financial system and the money and capital markets
within that system. The volume of financial wealth is huge and growing nearly every year.

• If we subtract total debts owed by U.S. nonfinancial businesses, households, and governments,
we obtain what is called net financial wealth. The total net financial wealth (Financial assets -
Debts) held by U.S. individuals and nonfinancial institutions was about $22 trillion in 2006.

Wealth holdings represent stored purchasing power that will be used in future periods as income
to finance purchases of goods and services and to increase societys standard of living. Therefore,
income is generated from the wealth function of the global financial system. Income emerges
from the average rate of return that our current wealth holdings (including any marketable skills
— human capital—we have) generate for us times the amount of our current wealth.
3.Liquidity Function For wealth stored in financial instruments, the global financial
marketplace provides a means of converting those instruments into cash with little risk of loss.
The worlds financial markets provide liquidity (immediately spendable cash) for savers who hold
financial instruments but are in need of money.

In modern societies, money consists mainly of currency and spendable deposits held in banks,
credit unions, and other depository institutions, amounting to almost $1.4 trillion in the United
States in 2006, and is the only financial instrument possessing perfect liquidity.

Money can be spent as it is without the necessity of converting it into some other form.
However, money generally earns the lowest rate of return of all assets traded in the financial
system, and its purchasing power is seriously eroded by inflation. Money is not the only means
of making purchases of goods and services. In many lesser-developed economies, simple
bartering—exchanging one good or service for another—performs many of the same services
that money provides in a developed economy.

4.Credit Function In addition to providing liquidity and facilitating the flow of savings into
investment to build wealth, the global financial markets furnish credit to finance current
consumption and investment spending by pledging future income, thus reducing spending
opportunities in the future. It thus represents the flipside of savings.

Credit consists of a loan of funds in return for a promise of future payment. Consumers need
credit to purchase a home, buy groceries, repair the family automobile, and retire outstanding
debts. Businesses draw on their lines of credit to stock their shelves with inventory, construct
new buildings, meet payrolls, and grant dividends to their stockholders. State, loc al, and federal
governments borrow to construct buildings and other public facilities and to cover daily cash
expenses until tax revenues flow in.

The volume of credit extended by the money and capital markets today is huge and growing. In
the United States alone total credit funds raised in U.S. financial markets in 2006 amounted to
more than $3.5 trillion—more than double the amount raised in the money and capital markets
only a decade before. Growth of the economy, inflation, and the tax deductibility of some
interest payments all appear to have fueled this rapid growth in credit usage by businesses,
households, and governments.

5.Payments Function The global financial system also provides a mechanism for making
payments for purchases of goods and services. Certain financial assets—including currency,
noninterest bearing checking accounts (referred to as demand deposits), and interest-bearing
checking accounts (often referred to as negotiable order of withdrawal or NOW accounts) —still
serve as a popular medium of exchange in making payments all over the globe (especially in the
United States).
Also high on the payments list and growing rapidly are debit and credit cards issued by banks,
credit unions, and retail stores. In the case of debit cards, a customer pays immediately for
purchases by electronically debiting his or her account in a depository institution. On the other
hand, in the case of credit cards the customer receives instant access to short-term credit when
contracting for purchases of goods and services.

Also on the rise are stored-value cards that many workers now receive on payday instead of a
payroll check; direct deposits in which funds are transferred electronically from the payers
account to the account of the payee. ATM cards that give the holder access to cash machines and
the ability to check account balances and transfer funds to cover any payments due.

If present trends continue, electronic means of payment, including computer terminals in homes,
offices, and stores and digital cash (accessed by an encoded plastic card) eventually may
completely replace checks and other pieces of paper as the principal means of paying in the
future. Indeed, electronic means of payment are growing rapidly today (especially in Europe),
while checks and other paper-based means of payment are declining in volume.

6.Risk Protection Function The financial markets offer businesses, consumers, and
governments protection against life, health, property, and income risks. This is accomplished,
first of all, by the sale of insurance policies. Policies marketed by life insurance companies
indemnify a family against possible loss of income following the death of a loved one. Property-
casualty insurers protect their policyholders against an incredibly wide array of personal and
property risks, ranging from ill health and storm damage to negligence on the highways. In
addition to making possible the sale of insurance policies, the money and capital markets have
been used by businesses and consumers to “self-insure” against risk; that is, holdings of wealth
are built up as protection against future losses.

The financial system permits individuals and institutions to engage in both risk sharing and risk
reduction. Risk sharing occurs when an individual or institution transfers risk exposure to
someone willing to accept that risk (such as an insurance company), while risk reduction usually
takes place when we diversify our wealth across a wide variety of different assets so that our
overall losses are likely to be more limited.

Overall, the risk protection business is huge. In the United States, for example, life insurance and
pension fund reserves to protect individuals and families against loss due to death and old age
tallied more than $13 trillion in 2006.

7..Policy Function Finally, in recent decades, the financial markets have been the principal
channel through which government has carried out its policy of attempting to stabilize the
economy and avoid inflation. By manipulating interest rates and the availability of credit,
government can affect the borrowing and spending plans of the public, impacting the growth of
jobs, production, and prices.
 As we will see later on, this task of economic stabilization has been given largely to central
banks, such as the Federal Reserve System in the United States, the Bank of England, the Bank
of Japan, and the new European Central Bank (the ECB).

1.4 Types of Financial Markets within the Global Financial System

The global financial system fulfills its various roles mainly through markets where financial
claims and financial services are traded (though in some lesser-developed economies
government dictation and even barter are used). These markets may be viewed as channels
through which moves a vast flow of loanable funds that is continually being drawn upon by
demanders of funds and continually being replenished by suppliers of funds.

The Money Market versus the Capital Market

The flow of funds around the world may be divided into different segments, depending on the
characteristics of financial claims being traded and the needs of different investors. One of the
most important divisions in the financial system is between the money market and the capital
market.

The money market is designed for the making of short-term loans. It is the institution through
which individuals and institutions with temporary surpluses of funds meet the needs of
borrowers who have temporary funds shortages (deficits). Thus, the money market enables
economic units to manage their liquidity positions. By convention, a security or loan maturing
within one year or less is considered to be a money market instrument. One of the principal
functions of the money market is to finance the working capital needs of corporations and to
provide governments with short-term funds in lieu of tax collections. The money market also
supplies funds for speculative buying of securities and commodities.

In contrast, the capital market is designed to finance long-term investments by businesses,

governments, and households. Trading of funds in the capital market makes possible the
construction of factories, highways, schools, and homes. Financial instruments in the capital
market have original maturities of more than one year and range in size from small loans to
multimillion dollar credits.

In the money market, commercial banks are the most important institutional supplier of funds
(lender) to both business firms and governments. Nonfinancial business corporations with
temporary cash surpluses also provide substantial short-term funds to the money market. On the
demand-for-funds side, the largest borrower in the U.S. money market is the Treasury
Department, which borrows billions of dollars weekly. Other governments around the world are
often among the leading borrowers in their own domestic money markets. The largest and best-
known corporations and securities dealers are also active borrowers in money markets around the
world. Due to the large size and strong financial standing of these well-known money market
borrowers and lenders, money market instruments are considered to be high-quality, “near
money” IOUs.

In contrast, the principal suppliers and demanders of funds in the capital market are more varied
than those in the money market. Families and individuals, for example, tap the capital market
when they borrow to finance a new home. Governments rely on the capital market for funds to
build schools and highways and provide essential services to the public. The most important
borrowers in the capital market are businesses of all sizes that issue long-term debt instruments
representing claims against their future revenues in order to cover the purchase of equipment and
the construction of new facilities. Ranged against these many borrowers in the capital market are
financial institutions, such as insurance companies, mutual funds, security dealers, and pension
funds, which supply the bulk of capital market funds.

Divisions of the Money and Capital Markets

The money market and the capital market may be further subdivided into smaller markets, each
important to selected groups of demanders and suppliers of funds. Within the money market, for
example, is the huge Treasury bill market. Treasury bills—short-term IOUs issued by many
governments around the world—are a safe and popular investment medium for financial
institutions, corporations of all sizes, and wealthy individuals.

Somewhat larger in volume is the market for certificates of deposit (CDs) issued by banks and
other depository institutions to raise funds in order to carry on their lending activities. Two other
important money market instruments that arise from large corporations borrowing money are
bankers acceptances and commercial paper. In another corner of the money market, federal funds
—the reserve balances of banks plus other immediately transferable monies—are traded daily in
huge volume. Another segment of the money market reaches around the globe to encompass
suppliers and demanders of short-term funds in Europe, Asia, and the Middle East. This is the
vast, largely unregulated Eurocurrency market, in which deposits denominated in the worlds
major trading currencies—for example, the dollar and the euro—are loaned to corporations and
governments around the globe.

The capital market, too, is divided into several sectors, each having special characteristics. For
example, one of the largest segments of the capital market is devoted to residential and
commercial mortgage loans to support the building of homes and business structures, such as
factories and shopping centers. In the United States, state and local governments sell their tax-
exempt (municipal) bonds in another sector of the capital market. Households borrow in yet
another segment, using consumer loans to make purchases ranging from automobiles to home
appliances. There is also an international capital market for borrowing by large corporations
represented by Eurobonds and Euro-notes.
Probably the best-known segment of the capital market is the market for corporate stock
represented by the major exchanges, such as the New York Stock Exchange (NYSE) and the
Tokyo Exchange, and a vast over-the-counter (OTC) market, including electronic stock trading
over the Internet. No matter where it is sold, however, each share of stock (equity) represents a
certificate of ownership in a corporation, entitling the holder to receive any dividends paid out of
current company earnings and to lay claim to any residual value left in the firms assets after all

its obligations are met. Businesses also sell a huge quantity of corporate notes and bonds in the
capital market each year to raise long-term funds. These securities, unlike shares of stock, are
pure IOUs, evidencing a debt owed by the issuing company. Each of these financial instruments
will be examined in detail in the chapters that lie ahead.

Open versus Negotiated Markets

Another distinction between markets in the global financial system focuses on Open markets
versus Negotiated Markets For example, some corporate bonds are sold in the open market to
the highest bidder and are bought and sold any number of times before they mature and are paid
off. In contrast, in the negotiated market for corporate bonds, securities generally are sold to one
or a few buyers under private contract.

An individual who goes to his or her local banker to secure a loan for new furniture enters the
negotiated market for personal loans. In the market for corporate stocks there are the major stock
exchanges, which represent the open market. Operating at the same time, however, is the
negotiated market for stock, in which a corporation may sell its entire stock issue to one or a
handful of buyers.

Primary versus Secondary Markets

The global financial markets also may be divided into primary markets and secondary
markets. The primary market is for the trading of new securities. Its principal function is raising
financial capital to support new investment in buildings, equipment, and inventories. You engage
in a primary-market transaction when you purchase shares of stock just issued by a company or
borrow money through a new mortgage to purchase a home.

In contrast, the secondary market deals in securities previously issued. Its chief function is to
provide liquidity to security investors—that is, provide an avenue for converting financial
instruments into cash. If you sell shares of stock or bonds you have been holding for some time
to a friend or call a broker to place an order for shares currently being traded on the American,
London, or Tokyo stock exchanges, you are participating in a secondary-market transaction.

The volume of trading in the secondary market is far larger than in the primary market. However,
the secondary market does not support new investment. Nevertheless, the primary and secondary
markets are closely intertwined. For example, a rise in security prices in the secondary market
usually leads to a similar rise in prices on primary-market securities, and vice versa. This
happens because many investors readily switch from one market to another in response to
differences in price or yield.

Spot versus Futures, Forward, and Option Markets

We may also distinguish between spot markets, futures or forward markets, and option markets.
A spot market is one in which assets are traded for immediate delivery (usually within one or
two business days). If you pick up the telephone and instruct your broker to purchase Telecon
Corporation stock at todays price, this is a spot market transaction. You expect to acquire
ownership of Telecon shares today.

A futures or forward market, on the other hand, is designed to trade contracts calling for the
future delivery of financial instruments. For example, you may call your broker and ask to
purchase a contract calling for delivery to you of $1 million in government bonds six months
from today. The purpose of such a contract would be to shift risk to some individual or
institution willing to bear that risk by agreeing upon a delivery price today rather than waiting six
months when government bonds might cost a lot more.

Finally, options markets also offer investors in the money and capital markets an opportunity to
reduce risk. These markets make possible the trading of contracts that give an investor the right
to either buy designated securities from or sell designated securities to the writer of the option at
a guaranteed price at any time during the life of the contract. Options make it possible to lock in
prices of assets no matter which way those prices move before the options expire.

Markets on the Net

 Bankrate.com at www.bankrate.com

 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

Queions based on the mentioned topics :

1.Why is it important for us to understand how the global financial system works?

2.What are the principal links between the financial system and the economy? Why
is each important to the other?

3.What are the principal functions or roles of the global financial system? How do

the money and capital markets fulfill those roles or functions?

4.What exactly is savings? Investment? Are these terms often misused by people on

the street? Why do you think this happens?

5.How and why are savings and investment important determinants of economic

growth? Do they impact our standard of living? How?

6.What seven vital functions does the financial system of money and capital

markets perform?

7.Why is each function of the financial system important to households,

businesses, and governments? What kinds of lives would we be living today if

there were no financial system or no financial markets?

8.What exactly do we mean by the term wealth? Why is it important?

9.What is net financial wealth? What does it reveal about each of us?

10.Can you explain what factors determine the current volume of financial wealth

and net financial wealth each of us has?

11.Can you distinguish between the following institutions?

Money market versus capital market

Open market versus negotiated market

Primary market versus secondary market

Spot market versus forward or futures market

12.If we follow the money and capital markets around the world each day it soon

becomes apparent that interest rates and asset prices in different markets tend

to move together, albeit with leads and lags. Why do you think this is so?
Referenece :

Money and Capital Markets ; Financial Institutions and Instruments in a Global Marketplace 10th Edition

Peter S. Rose

Texas A&M University

Milton H. Marquis

Florida State University