2. 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.

3.  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 tomorrow’s financial needs. 1-3

4. The Financial System  A collection of markets, institutions, laws, regulations, and techniques  Bonds, stocks, and other securities are traded  Interest rates are determined  Financial services are produced  Financial services are delivered around the world 1-4

5. 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. 1-5

6. 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 1-6

7. Circular Flow of Income, Payments, and Production in the Global Economic System Producing units (mainly businesses and governments) Consuming units (mainly households) 1-7

8. 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. 1-8

9. 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  1-9

10. 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 1-10

11. Types 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 markets Flow of production Product markets Goods and services Flow of payments Flow of payments for consumption and taxes Flow of incomes Factor markets Productive services 1-11

12. 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 1-12

13. 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. 1-13

14. The 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) 1-14

15. Function Performed by the Global Financial System and the Financial Markets: Savings  Provides a conduit for the public’s savings  Profitable outlet for utilization of savings  Relatively low-risk  Savings flow through the financial markets to investments allowing the economy to increase production 1-15

16. 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 1-16

17. 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 1-17

18. 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 1-18

19. 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 1-19

20. 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 1-20

21. 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.) 1-21

22. 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 1-22

23. 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 1-23

24. 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 1-24

25. 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. 1-25

26. Types of Financial Markets Within the Global Financial System  The money market may be subdivided  Treasury bills  Certificates of deposit (CDs)  Bankers’ acceptances  Commercial paper  Federal funds  Eurocurrencies 1-26

27. Types of Financial Markets Within the Global Financial System  The capital market may be subdivided  Mortgage loans  Tax-exempt (municipal) bonds  Consumer loans  Eurobonds and Euronotes  Corporate stock  Corporate notes and bonds 1-27

28. 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. 1-28

29. Three Types of Financial Markets  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.  Options markets enable contracts that grant the right to buy or sell certain securities at specific prices within a certain time. 1-29

30. 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. 1-30

31. 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 1-31

32. 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 1-32

33. 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, its principal institutions and instruments, and to central banks 1-33

34. The Plan of This Book  Part Four takes a closer look at commercial banks, credit unions, savings 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. 1-34

35. 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. 1-35

36. Markets on the Net  AOL Money and Finance at money.aol.com money.aol.com  Bankrate.com at www.bankrate.com/brm www.bankrate.com/brm  Bloomberg at Bloomberg. COM Bloomberg. COMBloomberg. COM  Chicago Board of Trade at www.cbot.com www.cbot.com  CNN Money at money.cnn.com/markets money.cnn.com/markets 1-36

37. Markets on the Net  Derivatives Concepts A-Z at www.finpipe.com/derivglossary.htm www.finpipe.com/derivglossary.htm  Federal Reserve of San Francisco frbsf.org frbsf.org  Finance Center at money.aol.com money.aol.com  Forbes at forbes.com forbes.com  Kiplinger at kiplinger.com kiplinger.com  Moody’s Investor Service at www.moodys.com www.moodys.com 1-37

38. Markets on the Net  Reuters at moneyline.com moneyline.com  Securities and Exchange Commission at www.sec.gov www.sec.gov  Smartmoney at smartmoney.com smartmoney.com  Standard and Poor’s Corporation at www.standardandpoors.com www.standardandpoors.com  The Economist at econo`mist.com econo`mist.com  The Financial Times at www.ftbusiness.com www.ftbusiness.com 1-38

39. Markets on the Net  The Wall Street Journal at www.wsj.com www.wsj.com  U.S. Bureau of Economic Analysis at www.bea.gov www.bea.gov  U.S. Bureau of the Census at www.census.gov www.census.gov  U.S. Treasury Department at www.publicdebt.treas.gov www.publicdebt.treas.gov  Yahoo Finance at finance.yahoo.com finance.yahoo.com 1-39

40. 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 1-40

41. 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 1-41

42. 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 1-42

43. Chapter Review  Factors tying all financial markets together  Credit, the common commodity  Speculation and arbitrage  The dynamic financial system  The plan of this book 1-43