Functions and Roles of the Financial System in the Global Economy

Money and Capital Markets

11C h a p t e r

Eighth Edition

Financial Institutions and Instruments in a Global Marketplace

Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

Functions and Roles of the Financial System in the Global EconomyFunctions and Roles of the Financial System in the Global Economy

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Learning Objectives

To understand the functions performed and the roles played by the system of financial markets and institutions in the global economy.

To explore several key terms and concepts of the money and capital markets.

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

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Introduction

The financial system is 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.

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Introduction

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.

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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.

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Flows within the Global Economic System

Land and other natural

resources

Labor and managerial

skills

Capital equipment

Flow of production

Flow of payments

Goods and services sold to the public

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Flows within the Global Economic System

Producing units (mainly business firms

and governments)Consuming units

(mainly households)

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The Role of Markets in the Global Economic System

In most economies around the world, markets carry out the complex task of allocating resources and producing goods and services.

The marketplace 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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Types of Markets

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

The factor markets allocate the factors of production to the owners of productive resources.

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

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Types of Markets

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

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Types of Markets

Producing units (mainly business

firms and governments)

Flow of producti

on

Flow of paymen

ts

Consuming units (mainly households)

Flow of funds (savings)

Flow of financial services, income, and

financial claims

Financial markets

Product markets

Factor markets Flow of incomes

Productive s

ervice

s

Goods and services

Flow of payments for

consumption and taxes

Flow of incomes

Productive services

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

The financial 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.

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

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The Global Financial System

Demanders of funds (mainly business

firms and governments)

Flow of loanable funds (savings)

Flow of financial services, incomes, and

financial claims

Suppliers of funds

(mainly households)

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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.

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Functions Performed by the Global Financial System and the Financial Markets

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.

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Functions Performed by the Global Financial System and the Financial Markets

Risk protection function. The financial markets around the world offer businesses, consumers, and governments protection against life, health, property, and income risks.

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

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Types of Financial MarketsWithin 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.

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Types of Financial MarketsWithin the Global Financial System

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.

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Types of Financial MarketsWithin the Global Financial System

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

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Types of Financial MarketsWithin the Global Financial System

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

Contracts calling for the future delivery of financial instruments are traded in the futures or forward market.

Contracts granting the right to buy or sell certain securities at specified prices within a certain period are traded in the options market.

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Credit, the Common Commodity. The shifting of borrowers among markets helps to weld the parts of the global financial system together and to bring the credit costs in the different markets into balance with one another.

Speculation and Arbitrage. Speculators who watch for profitable arbitrage opportunities help to maintain consistent prices among the markets.

Factors Tying All Financial Markets Together

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Factors Tying All Financial Markets Together

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.

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

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The Dynamic Financial System

The global financial system is rapidly changing.

In particular, there are trends toward the deregulation of financial institutions and services, the harmonization of regulations, and global integration, leading to more intense competition as well as the development of new financial services.

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The Plan of This Book

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

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The Plan of This Book

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

Part Five turns to the role of governments – federal, state, and local – within the global financial system.

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The Plan of This Book

Part Six focuses on the financial activities of nonfinancial business firms and consumers.

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

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Money and Capital Markets in Cyberspace

For more on the nature of the financial system, see http://homepages.uel.ac.uk/K.Bain/fimac223.html.

Help on planning for savings and investments is available at http://www.sec.gov/investor.shtml.

How much wealth does the U.S. really have and how unevenly is it distributed? See http://www.aei.org/research/description.htm#1.113 and http://woodrow.mpls.frb.fed.us/research/.

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Money and Capital Markets in Cyberspace

For a discussion of the important roles performed by capital markets within the financial system, see http://www1.worldbank.org/finance/.

For further discussion on the low U.S. savings rate, see http://www.bankrate.com/brm/.

For a discussion of the concept of arbitrage, see http://www.finpipe.com/derivglossary.htm.

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Money and Capital Markets in Cyberspace

Some experts see the Internet as a nearly perfect market. See, for example, http://www.wright.edu/~tdung/internet.htm.

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Chapter Review

Introduction 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 Factors Tying All Financial Markets Together The Dynamic Financial System

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Chapter Review

The Plan of This Book