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Chapter 1

Functions and Roles of the


Financial System in the
Global Economy
Slides by Yee-Tien (Ted) Fu
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McGraw-Hill/Irwin
Money and Capital Markets, 9/e 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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 tomorrows financial needs.
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Money and Capital Markets, 9/e 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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
and governments)
Consuming units
(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
Producing units
(mainly business
firms and
governments)
Consuming units
(mainly households)
Flow of funds
(savings)
Flow of financial
services, income, and
financial claims
Financial markets
Product markets
Factor markets
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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
Flow of financial
services, incomes, and
financial claims
Demanders
of funds
(mainly
business
firms and
governments)
Flow of loanable funds
(savings)
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 publics 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 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 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 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 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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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.
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.
Financial markets in the real world. 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, 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 worlds 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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Money and Capital Markets, 9/e 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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Money and Capital Markets, 9/e 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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Markets on the Net
Bankrate.com at www.bankrate.com/brm
Chicago Board of Trade at www.cbot.com
Derivatives Concepts A-Z at
www.finpipe.com/derivglossary.htm
Moodys Investor Service at www.moodys.com
Securities and Exchange Commission at www.sec.gov
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Markets on the Net
Standard and Poors Corporation at
www.standardandpoors.com
The Financial Times at www.ftbusiness.com
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
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Money and Capital Markets, 9/e 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Markets on the Net
U.S. Treasury Department at www.publicdebt.treas.gov
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Money and Capital Markets, 9/e 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/Irwin
Money and Capital Markets, 9/e 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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Money and Capital Markets, 9/e 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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McGraw-Hill/Irwin
Money and Capital Markets, 9/e 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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