Chapter 1Chapter 1

Functions and Roles of the Functions and Roles of the Financial System in the Financial System in the

Global EconomyGlobal Economy

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Learning Objectives Learning Objectives

You will understand the functions You will understand the functions performed and the roles played by the performed and the roles played by the system of financial markets and system of financial markets and financial institutions in the global financial institutions in the global economy and in our daily lives.economy and in our daily lives.

You will discover how important the You will discover how important the financial system is to increasing our financial system is to increasing our standard of living, generating new jobs, standard of living, generating new jobs, and building our savings to meet and building our savings to meet tomorrow’s financial needs.tomorrow’s financial needs.

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The Financial SystemThe Financial System

A collection of markets, A collection of markets, institutionsinstitutions, , laws, regulations, and techniqueslaws, regulations, and techniques

Bonds, stocks, and other securities are Bonds, stocks, and other securities are tradedtraded

Interest rates are determinedInterest rates are determinedFinancial services are produced Financial services are produced Financial services are delivered around Financial services are delivered around

the worldthe world

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The Primary Task of the Financial SystemThe Primary Task of the Financial System

It moves scarce loanable funds. It moves scarce loanable funds. Funds are shifted from those who save. Funds are shifted from those who save. The funds are moved to those who The funds are moved to those who

borrow to buy goods and services and borrow to buy goods and services and to make investments in new equipment to make investments in new equipment and facilities.and facilities.

That movement enables the global That movement enables the global economy to grow and the standard of economy to grow and the standard of living to increase.living to increase.

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Flows within the Global Flows within the Global Economics SystemEconomics System

Basic function of the Basic function of the economic systemeconomic system Allocate scarce resources; land, labor, Allocate scarce resources; land, labor,

management skill, and capitalmanagement skill, and capital Produce the goods and services needed by Produce the goods and services needed by

societysocietyThe global economy generates a flow of The global economy generates a flow of

production in return for a flow of production in return for a flow of paymentspayments

The circular flow of production and The circular flow of production and income is interdependentincome is interdependent

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

Producing units (mainly businesses and

governments)Consuming units

(mainly households)

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The Role of Markets The Role of Markets in the Global Economic Systemin the Global Economic System

Most economies around the world rely Most economies around the world rely principally upon principally upon marketsmarkets to carry out to carry out the complex task of allocating scarce the complex task of allocating scarce resources.resources.

The marketplace is The marketplace is dynamicdynamic. It . It determines what goods and services determines what goods and services will be produced and in what quantities will be produced and in what quantities through their through their pricesprices..

Markets also distribute Markets also distribute incomeincome by by rewarding superior producers with rewarding superior producers with increased profits, higher wages, and increased profits, higher wages, and other economic benefits.other economic benefits.

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Three Types of MarketsThree Types of Markets

The The factor marketsfactor markets Allocate factors of production (land, labor, Allocate factors of production (land, labor,

skills, capital)skills, capital) Distribute income (wages, rent) to the Distribute income (wages, rent) to the

owners of productive resourcesowners of productive resources

TheThe product markets product markets Allocate goods and servicesAllocate goods and services Consuming units use most of their income Consuming units use most of their income

in this marketin this market

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Three Types of MarketsThree Types of Markets

The The financial marketsfinancial markets Allocate savings to individuals and Allocate savings to individuals and

institutionsinstitutions Those that need more funds for spending Those that need more funds for spending

than are provided by their current incomesthan are provided by their current incomes

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Types of MarketsTypes of Markets

Producing units (mainly businesses and governments)

Consuming units (mainly households)

Flow of funds (savings)

Flow of financial services, income, and

financial claims

Financial marketsFlow of p

roduction

Product markets

Goods and servicesFlow of p

ayments

Flow of payments for

consumption and taxes

Flow of incomesFlow of incomes Factor markets

Productive s

ervice

sProductive services

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

Nature of savingsNature of savings Households: current income – tax Households: current income – tax

payments – consumption expenditurespayments – consumption expenditures Businesses: retained earningsBusinesses: retained earnings Governments: current revenues – Governments: current revenues –

expendituresexpendituresNature of investmentNature of investment

Households: purchase of a homeHouseholds: purchase of a home Businesses: expenditures on capital goods Businesses: expenditures on capital goods

and inventoriesand inventories Governments: building/maintaining public Governments: building/maintaining public

facilitiesfacilities1-12

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

The financial markets enable the The financial markets enable the exchange of current income for future exchange of current income for future incomeincome and the and the transformation of transformation of savings into investmentsavings into investment so that so that production, employment, and income production, employment, and income can grow, and living standards improve.can grow, and living standards improve.

The suppliers of funds to the financial The suppliers of funds to the financial system expect not only to recover their system expect not only to recover their original funds but also to earn original funds but also to earn additional income as a reward for additional income as a reward for waiting and assuming risk.waiting and assuming risk.

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The Global Financial SystemThe Global Financial System

Flow of financial services, incomes, and

financial claims

Demanders of funds (mainly

businesses and

governments)

Flow of loanable funds (savings) Suppliers of

funds (mainly

households)

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Function Performed by the Global Financial Function Performed by the Global Financial System and the Financial Markets: SavingsSystem and the Financial Markets: Savings

Provides a conduit for the public’s Provides a conduit for the public’s savingssavings Profitable outlet for utilization of savingsProfitable outlet for utilization of savings Relatively low-riskRelatively low-risk

Savings flow through the financial Savings flow through the financial markets to investments allowing the markets to investments allowing the economy to increase productioneconomy to increase production

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Function Performed by the Global Financial Function Performed by the Global Financial System and the Financial Markets: WealthSystem and the Financial Markets: Wealth

Wealth is the value of accumulated Wealth is the value of accumulated savings built up over timesavings built up over time Financial instruments provide an excellent Financial instruments provide an excellent

way to store wealthway to store wealth Financial instruments do not depreciate and Financial instruments do not depreciate and

often generate incomeoften generate income Financial instruments have less risk than Financial instruments have less risk than

many other forms of wealth storingmany other forms of wealth storing

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Function Performed by the Global Financial Function Performed by the Global Financial System and the Financial Markets: WealthSystem and the Financial Markets: Wealth

Financial wealth is extensiveFinancial wealth is extensive $55 trillion in US financial assets held by $55 trillion in US financial assets held by

domestic nonfinancial businesses domestic nonfinancial businesses $11 trillion in US financial assets held by $11 trillion in US financial assets held by

international investors international investors

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ExampleExample

Wealth from prior period $1000Wealth from prior period $1000Savings from this period $50Savings from this period $50Rate of return on wealth 10%Rate of return on wealth 10%

Return =0.10*($1000) = $100Return =0.10*($1000) = $100

Wealth at the end of the periodWealth at the end of the period$1000+$50+$100 = $1150$1000+$50+$100 = $1150

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Function Performed by the Global Financial Function Performed by the Global Financial System and the Financial Markets: LiquiditySystem and the Financial Markets: Liquidity

Provide liquidity for savers who hold Provide liquidity for savers who hold financial instruments but are in need of financial instruments but are in need of moneymoney

Money is mainly currency and deposits Money is mainly currency and deposits held in depository institutionsheld in depository institutions Can be spent without need of conversionCan be spent without need of conversion Earns the lowest rate of return of all Earns the lowest rate of return of all

financial assetsfinancial assets

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Function Performed by the Global Financial Function Performed by the Global Financial System and the Financial Markets: CreditSystem and the Financial Markets: Credit

Furnish credit to finance current Furnish credit to finance current consumption and investment spendingconsumption and investment spending Accessed by pledging future incomeAccessed by pledging future income The flipside of savingsThe flipside of savings

Volume of credit in the United States is Volume of credit in the United States is huge and growinghuge and growing Total credit funds raised in the US in 2005 is Total credit funds raised in the US in 2005 is

$3.4 trillion$3.4 trillion More than double what it was a decade More than double what it was a decade

beforebefore

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Function Performed by the Global Financial Function Performed by the Global Financial System and the Financial Markets: PaymentSystem and the Financial Markets: Payment

A mechanism for making payments for A mechanism for making payments for purchases of goods and servicespurchases of goods and services Certain financial assets have been popular Certain financial assets have been popular

means of exchange (currency, demand means of exchange (currency, demand deposits, etc.)deposits, etc.)

Growing in popularity are debit and credit Growing in popularity are debit and credit cardscards

Many other instruments are also growing in Many other instruments are also growing in popularity (ATM, Stored-value cards, etc.)popularity (ATM, Stored-value cards, etc.)

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Function Performed by the Global Financial Function Performed by the Global Financial System: Risk ProtectionSystem: Risk Protection

The financial markets offer protection The financial markets offer protection against life, health, property, and against life, health, property, and income risksincome risks

Permits individuals and institutionsPermits individuals and institutionsEngage in Engage in risk-sharingrisk-sharing Engage in Engage in risk reductionrisk reduction

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Function Performed by the Global Financial Function Performed by the Global Financial System and the Financial Markets: PolicySystem and the Financial Markets: Policy

A channel through which governments A channel through which governments may attempt to influence the economymay attempt to influence the economy Affect borrowing and spending plansAffect borrowing and spending plans Impact the growth rates of jobs, production, Impact the growth rates of jobs, production,

and prices and prices

The task of economic stabilization has The task of economic stabilization has been given largely to central banksbeen given largely to central banks

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Functions Performed by the Global Functions Performed by the Global Financial System and the Financial MarketsFinancial System and the Financial Markets

There are many financial services that There are many financial services that are widely sought afterare widely sought after Payments servicesPayments services Thrift servicesThrift services Insurance servicesInsurance services Credit servicesCredit services Hedging servicesHedging services Agency servicesAgency services

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Types of Financial MarketsTypes of Financial MarketsWithin the Global Financial SystemWithin the Global Financial System

The The money marketmoney market is the market for short- is the market for short-term (one year or less) loans. term (one year or less) loans.

The The capital marketcapital market finances long-term finances long-term investments by businesses, governments, investments by businesses, governments, and households.and households.

In particular, governments borrow from In particular, governments borrow from commercial banks in the money market, while commercial banks in the money market, while in the capital market, insurance companies, in the capital market, insurance companies, mutual funds, security dealers, and pension mutual funds, security dealers, and pension funds supply the funds for businesses.funds supply the funds for businesses.

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Types of Financial MarketsTypes of Financial MarketsWithin the Global Financial SystemWithin the Global Financial System

The money market may be subdividedThe money market may be subdivided Treasury bills Treasury bills Certificates of deposit (CDs)Certificates of deposit (CDs) Bankers’ acceptances Bankers’ acceptances Commercial paper Commercial paper Federal fundsFederal funds EurocurrenciesEurocurrencies

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Types of Financial MarketsTypes of Financial MarketsWithin the Global Financial SystemWithin the Global Financial System

The capital market may be subdivided The capital market may be subdivided Mortgage loans Mortgage loans Tax-exempt (municipal) bonds Tax-exempt (municipal) bonds Consumer loans Consumer loans Eurobonds and EuronotesEurobonds and Euronotes Corporate stockCorporate stock Corporate notes and bondsCorporate notes and bonds

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Types of Financial MarketsTypes of Financial MarketsWithin the Global Financial Within the Global Financial

SystemSystem In In open marketsopen markets, financial instruments are , financial instruments are

sold to the highest bidder, and can be traded sold to the highest bidder, and can be traded as often as is desirable before maturity.as often as is desirable before maturity.

In In negotiated marketsnegotiated markets, the instruments are , the instruments are sold to one or a few buyers under private sold to one or a few buyers under private contract.contract.

Financial capital is raised when new Financial capital is raised when new securities are sold in the securities are sold in the primary marketsprimary markets. .

Security trading in the Security trading in the secondary marketssecondary markets then provides liquidity for the investors.then provides liquidity for the investors.

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Three Types of Financial MarketsThree Types of Financial Markets

In the In the spot marketspot market, assets are traded for , assets are traded for immediate delivery (usually within one immediate delivery (usually within one or two business days).or two business days).

A A futuresfutures or or forward marketforward market is designed is designed to trade contracts calling for the future to trade contracts calling for the future delivery.delivery.

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

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Factors Tying All Financial Factors Tying All Financial Markets TogetherMarkets Together

Credit, the common commodity.Credit, the common commodity. The The shifting of borrowers among markets shifting of borrowers among markets helps to weld the financial system helps to weld the financial system together and to balance the costs of together and to balance the costs of credit in the different markets.credit in the different markets.

Speculation and arbitrage.Speculation and arbitrage. Speculators Speculators who gamble on their market forecasts who gamble on their market forecasts and arbitrageurs who watch for and arbitrageurs who watch for profitable arbitrage opportunities help profitable arbitrage opportunities help to level out prices and maintain price to level out prices and maintain price consistency among the markets.consistency among the markets.

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The Dynamic Financial SystemThe Dynamic Financial System

The global financial system rapidly The global financial system rapidly changing into a new systemchanging into a new system

The trend toward global integration of The trend toward global integration of financial systemsfinancial systems Powered by innovations as new financial Powered by innovations as new financial

services and instruments continually services and instruments continually appear to attract customersappear to attract customers

Non-financial companies invading the Non-financial companies invading the financial services fieldfinancial services field

Aided by the gradual deregulationAided by the gradual deregulation Benefiting from increasing harmonization of Benefiting from increasing harmonization of

regulationsregulations1-31

The Dynamic Financial SystemThe Dynamic Financial System

The results are major changes to the The results are major changes to the marketmarket Increasingly intense competition Increasingly intense competition Many new financial servicesMany new financial services Increased riskIncreased risk A wave of mergers among financial A wave of mergers among financial

institutionsinstitutions

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The Plan of This BookThe Plan of This Book

Part OnePart One provides an overview of the provides an overview of the global financial system – its role in the global financial system – its role in the world’s economy and basic world’s economy and basic characteristics.characteristics.

Part TwoPart Two examines the forces that examines the forces that shape interest rates and the prices of shape interest rates and the prices of financial instruments.financial instruments.

Part ThreePart Three draws our attention to the draws our attention to the money market, its principal institutions money market, its principal institutions and instruments, and to central banksand instruments, and to central banks

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The Plan of This BookThe Plan of This Book

Part FourPart Four takes a closer look at takes a closer look at commercial banks, credit unions, commercial banks, credit unions, savings associations, money market savings associations, money market funds, insurance companies, pension funds, insurance companies, pension funds, mutual funds, and other private funds, mutual funds, and other private financial-service firms.financial-service firms.

Part FivePart Five turns to the role of turns to the role of governments (federal, state, and local) governments (federal, state, and local) and business firms within the global and business firms within the global financial system.financial system.

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The Plan of This BookThe Plan of This Book

Part SixPart Six focuses on the financial focuses on the financial characteristics of consumers – characteristics of consumers – individuals and families.individuals and families.

Part SevenPart Seven is devoted to the is devoted to the international financial system and future international financial system and future trends in global finance.trends in global finance.

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Markets on the NetMarkets on the Net

AOL Money and Finance at AOL Money and Finance at money.aol.commoney.aol.com

Bankrate.com at Bankrate.com at www.bankrate.com/brmwww.bankrate.com/brm

Bloomberg at Bloomberg at Bloomberg. COMBloomberg. COMChicago Board of Trade at Chicago Board of Trade at

www.cbot.comwww.cbot.comCNN Money at CNN Money at money.cnn.commoney.cnn.com/markets/markets

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Markets on the NetMarkets on the Net

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

Federal Reserve of San Francisco Federal Reserve of San Francisco frbsf.orgfrbsf.org

Finance Center at Finance Center at money.aol.commoney.aol.comForbes at Forbes at forbes.comforbes.comKiplinger at Kiplinger at kiplinger.comkiplinger.comMoody’s Investor Service at Moody’s Investor Service at

www.moodys.comwww.moodys.com

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Markets on the NetMarkets on the Net

Reuters at Reuters at moneyline.commoneyline.comSecurities and Exchange Commission Securities and Exchange Commission

at at www.sec.govwww.sec.govSmartmoney at Smartmoney at smartmoney.comsmartmoney.comStandard and Poor’s Corporation at Standard and Poor’s Corporation at

www.standardandpoors.comwww.standardandpoors.comThe Economist at The Economist at econo`mist.comecono`mist.comThe Financial Times at The Financial Times at

www.ftbusiness.comwww.ftbusiness.com

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Markets on the NetMarkets on the Net

The Wall Street Journal at The Wall Street Journal at www.wsj.comwww.wsj.comU.S. Bureau of Economic Analysis at U.S. Bureau of Economic Analysis at

www.bea.govwww.bea.govU.S. Bureau of the Census at U.S. Bureau of the Census at

www.census.govwww.census.govU.S. Treasury Department at U.S. Treasury Department at

www.publicdebt.treas.govwww.publicdebt.treas.govYahoo Finance at Yahoo Finance at finance.yahoo.comfinance.yahoo.com

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Chapter ReviewChapter Review

Introduction to the financial systemIntroduction to the financial systemThe global economy and the financial The global economy and the financial

systemsystem Flows within the global economic systemFlows within the global economic system The role of markets in the global economic The role of markets in the global economic

systemsystem Types of marketsTypes of markets The financial markets and the financial The financial markets and the financial

system: channel for savings and investmentsystem: channel for savings and investment

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Chapter ReviewChapter Review

Functions performed by the global Functions performed by the global financial system and the financial financial system and the financial marketsmarkets Savings functionSavings function Wealth functionWealth function Liquidity functionLiquidity function Credit functionCredit function Payments functionPayments function Risk protection functionRisk protection function Policy functionPolicy function

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Chapter ReviewChapter Review

Types of financial markets within the Types of financial markets within the global financial systemglobal financial system The money market versus the capital The money market versus the capital

marketmarket Divisions of the money and capital marketsDivisions of the money and capital markets Open versus negotiated marketsOpen versus negotiated markets Primary versus secondary marketsPrimary versus secondary markets Spot versus futures, forward, and option Spot versus futures, forward, and option

marketsmarkets

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Chapter ReviewChapter Review

Factors tying all financial markets Factors tying all financial markets togethertogether Credit, the common commodityCredit, the common commodity Speculation and arbitrageSpeculation and arbitrage

The dynamic financial system The dynamic financial system The plan of this bookThe plan of this book

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