Role of the financial system
The financial system consists of financial markets, institutions and money.
Financial markets – people buy and sell financial instruments such as stocks, bonds, future contracts or mortgage-backed securities.
Financial markets has 5 primary functions:
1. Facilitating the flow of funds
2. Providing the mechanism for the settlement of transactions
3. Generating information for the settle of transactions
4. Providing means for the transfer and management of risk
5. Providing ways of dealing with the incentive problems that arise in financial contracting
Flow of funds
Financial institutions allow the flow of funds from savers/surplus spending units (SSU, an economic unit whose income in a period exceeds expenditure) to borrowers/deficit spending unit (DSU, an economic unit whose income in a period is less than expenditure).
Financial intermediaries are financial institutions that issue liabilities to SSU’s and use the funds obtained to acquire liabilities of DSU’s.
Money acts as a medium of exchange and it is important to the efficiency of the financial system. It overcomes the divisibility problem caused if the mediums of exchange are not equal. Money helps by providing all participants with a means of exchanging value.
The role of the financial system is to permit the flow and efficient allocation of funds throughout the economy. Check pg 6 figure 1.2.
SSU’s are either risk averse, risk neutral or risk taking.
The ease at which financial instruments can be converted back into cash without losing capital value is referred to as liquidity. The earlier the returns are realised, the lower the risk because with time comes uncertainty.
For financial markets to operate efficiently they need to provide a range of financial instruments to meet the return, risk, timing and liquidity preferences of the market participants. Providing this will promote an increased flow of funds because savers will be able