Chapter 1

Functions and Roles of the

Financial System in the
Global Economy

Slides by Yee-Tien (Ted) Fu

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 Learning Objectives 

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

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Introduction to the Financial System

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 to the Financial System

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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Circular Flow of Income, Payments, and Production

in the Global Economic System

Producing units
(mainly business firms Consuming units
and 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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Types of Markets

• There are essentially three types of markets within the global

economic system.
 The factor markets allocate factors of production (land, labor,
skills, capital) and distribute income (wages, rent) to the
owners of productive resources.
 Consuming units use most of their income from factor markets
to purchase goods and services in the 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
Product markets F
co low
ns o
n ts um f p
me ion Go pt aym
y od ion e
f pa uct sa a n n ts
w
o r od nd d t f or
o p ser ax
Fl of vic es
l ow Financial markets es
F
Flow of funds
Producing units (savings)
(mainly business Consuming units
firms and Flow of financial (mainly households)
governments) services, income, and
financial claims
Pr F l ow es es
od o m ic
uc of in n c r v
tiv c o o f i e se
es
er mes Factor markets F low ctiv
u
vic d
es o
Pr
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The 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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The 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 can 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
business (mainly
firms and Flow of financial households)
governments) services, incomes, and
financial claims

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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, in
the form of currency, checking accounts, debit cards, credit
cards, digital cash, etc.

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Functions Performed by the Global Financial

System and the Financial Markets

• Risk protection function. The financial markets offer

protection against life, health, property, and income risks, by
permitting individuals and institutions to engage in both risk-
sharing and risk reduction.
• Policy function. The financial markets are a channel through
which governments may attempt to stabilize the economy and
avoid inflation.

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Functions Performed by the Global Financial

System and the Financial Markets

• The financial services that are most widely sought by the

public include:
- Payments services
- Thrift services
- Insurance services
- Credit services
- Hedging services
- Agency services

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Types of Financial Markets

Within the 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 Markets

Within the Global Financial System

• The money market may be subdivided into Treasury bills,

certificates of deposit (CDs), bankers’ acceptances,
commercial paper, federal funds .
• The capital market may be subdivided into mortgage loans,
,consumer loans, Eurobonds and Euronotes, corporate stock,
and corporate notes and bonds.

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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 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 new 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 Markets

Within the Global Financial System

• In the spot market, assets are traded for immediate delivery

(usually within one or two business days).
• A futures or forward market is designed to trade contracts
calling for the future delivery of financial instruments.
• Options markets enable contracts that grant the right to buy or
sell certain securities at specific prices within a certain time to
be traded.

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The Dynamic Financial System

• The global financial system is rapidly changing.

• In particular, the trend towards the global integration of
financial systems has been aided by the gradual deregulation
of financial institutions and services as well as the increasing
harmonization of their regulations.

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The Dynamic Financial System

• The results have been increasingly intense competition, many

new financial services, increased risk, and a wave of mergers
among financial institutions.

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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 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 takes a closer look at commercial banks, credit

unions, savings and loan associations, money market funds,
insurance companies, pension funds, mutual funds, and other
private financial-service firms.
• Part Five turns to the role of governments (federal, state, and
local) and business firms within the global financial system.

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The Plan of This Book

• Part Six focuses on the financial characteristics of consumers

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

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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
- Perfect and Efficient Markets
- Financial Markets in the Real World: Imperfection and
Asymmetry
• The Dynamic Financial System
• The Plan of This Book

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