Chapter 1

Functions and Roles of the

Financial System in the
Global Economy

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 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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Coverage
Economic Systems
Circular Flow in the Economy and The
Place of FMs in It
Financial System
Economic Functions of FMI
Types of FMs
Securities Traded in FM
FIs and Market Regulations
Financial Globalization
 Economic Systems

Division as per the mode of exchange

Barter System
Money based

(From Barter to Banknote)

Barter to Banknote to Plastic Money
Commodity Mode of Money
Live stocks, sacks of cereal grains (Shekel has come from
there)
Cowry shell, beads
Metals (1500BC to 1000BC)
Bronze, iron, silver, gold
Paper Money
First by Song Dynasty in China during the 11th century and
was introduced in Europe in 13th century
Bank came into operations in Italy. First bank to be established
was established in Venice with guarantee from the State in 1157.
Plastic Money
Barclay Credit Bank of UK first introduced credit card in 1966
Method of Economic Governance

Modern Economic Systems

Capitalist/Market Economy
Socialist/Centrally Command
Economy
Mixed Economy
 Fundamental differences between
economic systems
Differences Capitalism/ Communism/ Mixed
Market Centrally Economy
Economy/ Planned
Economy/State
Controlled
Economy
Ownership of Individuals and State The State and
Means of firms, directly Individuals
Production and/ or and firms
indirectly.

Coordination Market through Budget through Budget and

of Economic price plant managers market
Activities
 Circular Flow in the Economy
In economics the term circular flow
refers to a simple economic model
which describes the reciprocal
circulation of income between
producers and consumers.
 Circular Flow

In the circular flow model, the inter-

dependent entities of producer and
consumer are referred to as "firms" and
"households" respectively and provide
each other with factors in order to
facilitate the flow of income.
 Circular Flow

Firms provide consumers with

goods and services in exchange
for consumer expenditure and
"factors of production" from
households.
Economy-wide circular flow of
goods and services
Circular Flow of Goods and Services in
the Economy
Circular Flow of Goods and Services
in the Global Economy
 The Financial System

A collection of markets, institutions, laws,

regulations, and techniques where
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 Consuming units
governments) (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

Financial markets
Flow of funds
Producing units (savings)
(mainly businesses Consuming units
and governments) Flow of financial (mainly households)
services, income, and
financial claims

Factor markets

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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 Flow of loanable funds

of funds (savings) Suppliers of
(mainly funds
businesses (mainly
and Flow of financial households)
governments) services, incomes, and
financial claims

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 Economic Functions of FMIs

Savings Function
Wealth Function
Liquidity Function
Credit Function
Payments Function
Risk Protection Function
Policy Function
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 short-

term (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
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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 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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 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

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 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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