Professional Documents
Culture Documents
Aims
Explain the theory and purpose of financial intermediation. Describe the structure of financial markets Show that financial intermediation is welfare superior to direct transformation of current consumption to future consumption. Describe the process of financial intermediation and the markets that enable its efficient functioning.
Financial Intermediation
The mechanism whereby surplus funds from ultimate savers are matched to deficits incurred by ultimate borrowers The process by which ultimate savers are matched to ultimate borrowers. Saving = Income Consumption Typically decisions to save are made independently of decisions to invest
Chanelling of Funds
In a simple economy we have firms and households Households are the savers and firms are the investors. The mechanism by which households save is by demanding securities from firms The mechanism by which firms invest is by supplying securities to households These securities are claims to the assets of the firm
HOUSEHOLDS
FIRMS
FINANCIAL CLAIMS
Direct Finance
Lending and borrowing can occur as a result of direct transacting. But there are costs associated with direct finance Search costs searching for potential transactors Verification costs costs in evaluating investment proposals Monitoring costs costs of monitoring the actions of borrowing Enforcement costs costs of enforcing contracts
HOUSEHOLDS
Financial Intermediary
FIRMS
Financial Claims
Financial Intermediary
3. Government
4. Foreigners
Direct Finance
Financial Assets
H = high powered money = Currency + bank reserves D = Stock of Bank deposits L = Stock of Bank loans Q = Stock of Private securities B = Stock of government bonds F = Stock of foreign financial assets A superscript d represents demand and a superscript s represents supply.
X t X t X t 1
Flow of Funds
S D B d Q d F d I (G T ) ( X M ) Q s L B s H F s S I (G T ) ( X M ) 0 ( I S ) (G T ) ( X M ) 0 (Q s Q d ) (B s B d ) (F s F d ) (L H D)
C0
Y0
Period 0
0B = (1+r)0A
-(1+r)
Period 0
Borrowing
E A A
Lending
B
B E
Summary
We have looked at the process and theory of financial intermediation. Efficient direct finance is conducted through the mechanism of an efficient capital market Indirect finance is through the process of a financial intermediary. Financial intermediation is welfare superior to non-market direct financing.