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CHAPTER 1

Differences Capitalism/ Communism/ Mixed


Market Economy/ Centrally Planned Economy
Economy/State Controlled
Economy

Ownership of Individuals and State The State and


Means of firms, directly and/ Individuals
Production or indirectly. and firms

Coordination of Market through Budget through plant Budget and


Economic price managers market
Activities

In economics the term circular flow refers to a simple economic model which describes the reciprocal
circulation of income between producers and consumers

 In the circular flow model, the inter-dependent entities of producer and consumer are referred
to as "firms" and "households" respectively and provide each other with factors in order to
facilitate the flow of income.
 Firms provide consumers with “goods and services” in exchange for consumer expenditure
and "factors of production" from households.
The Financial System
A collection of markets, institutions, laws, regulations, and techniques where
 Bonds, stocks, and other securities are traded
 Interest rates are determined
 Financial services are produced
 Financial services are delivered around the world

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

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

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.

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
The financial markets
Allocate savings to individuals and institutions
Those that need more funds for spending than are provided by their current incomes

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

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.
Economic Functions of FMIs
 Savings Function, Wealth Function, Liquidity Function, Credit Function, Payments Function
Risk Protection Function and Policy Function.

Economic Functions of FMIs


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

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
Financial wealth is extensive

EXAMPLE NUMERICAL
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

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

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

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.)

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
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

There are many financial services that are widely sought after
1. Payments services
2. Thrift services
3. Insurance services
4. Credit services
5. Hedging services
6. Agency services

Types of Financial Markets Within the Global Financial System

CLASSIFICATION OF FINANCIAL MARKET


BASED ON MATURITY STRUCTURE- MONEY AND CAPITAL
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

BASED ON TRADING STRUCTURE- PRIMARY AND SECONDARY


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.

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

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

The results are major changes to the market


Increasingly intense competition
Many new financial services
Increased risk
A wave of mergers among financial institutions

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

 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

 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


 Credit, the common commodity
 Speculation and arbitrage
 The dynamic financial system
 The plan of this book
The opening chapter of Money and Capital Markets presents us with an introduction to the global financial system
in which the money and capital markets play central roles. It also highlights the principal institutions that shape
the character and functioning of the world’s financial marketplace.

 The financial system produces and distributes financial services to the public. Among its most important
services is a supply of credit which allows businesses, households, and governments to invest and acquire
assets they need for daily economic activity. The financial system of money and capital markets
determines both the amount and cost of credit available. In turn, the supply and cost of credit affect the
health and growth of the global economy and our own economic welfare.

 Credit and other financial services are offered for sale in the institution we call a market. Markets allocate
financial and physical resources that are scarce relative to demand.

 Another key role played by markets operating within the financial system is to stimulate an adequate
volume of savings (i.e., funds left over after current consumption spending by households and earnings
retained by businesses) and to transform those savings into an adequate volume of investment (i.e., the
purchase of capital goods and the buildup of inventories of goods to sell). In turn, investment generates
new products and services and creates new jobs and new businesses, resulting in faster economic growth
and a higher standard of living. By determining interest rates within the financial system, the money and
capital markets bring the volume of savings generated by the public into balance with the volume of
investment in new plant and equipment and in inventories of goods and resources available for sale.

 One important way to view the financial system of money and capital markets is by examining its seven
key functions or roles in meeting the financial needs of individuals and institutions, including generating
and allocating savings, stimulating the accumulation of wealth, providing liquidity for spending, providing a
mechanism for making payments, supplying credit to aid in the purchase of goods and services, providing
risk protection services, and supplying a channel for government policy in helping achieve the nation’s
economic goals (including maximum employment, low inflation, and sustainable economic growth).

 The markets that serve the financial system may be classified in several different ways, including money
markets, supplying short-term loans (credit) of less than a year, and capital markets, supplying long-term
loans (credit) lasting longer than a year. There are also open markets where anyone may participate as
buyer or seller versus negotiated markets where only a few bidders seek to acquire assets. There
are primary versus secondary markets; in the former, new financial instruments are traded in contrast to
the latter where existing instruments are exchanged. Additional types of financial markets that make up
the global financial system include markets that deal in the immediate purchase or sale of goods or
services, called spot markets, and those that promise future delivery, known as futures, forward, or option
markets.

 While many different segments make up the money and capital markets around the globe, all these
markets share the common purpose of supplying credit to answer global demands for borrowed funds and
all encourage saving to make investment (and, therefore, economic growth) possible. Funds flow easily
and, for the most part, smoothly from one segment of the marketplace to another, spurred by such forces
as arbitrage and speculation. For example, arbitrage causes credit, savings, and investment to flow toward
those market segments that offer the most favorable returns, helping different markets to price resources
more consistently and eliminate price disparities for the same goods and services. Prices are also brought
into balance from market to market by the force of speculation, which seeks out underpriced and
overpriced services and goods.

 Finally, the money and capital markets have revealed themselves to be efficient institutions, gathering and
quickly using all relevant information to price credit and other financial services. Some are
nearly perfect markets where competition sets prices and allocates resources. However, important
imperfections do exist within the financial system where competition is sometimes restricted and excess
profits are sometimes earned by those who stifle competition or gain access to inside information not
freely available to all due to asymmetries within the marketplace.

QUIZ CHAPTER1
The _______ is designed to finance long-term investments, making possible
the construction of factories, office buildings, highways, bridges, schools,
homes, and apartments.

B)
capital market
Providing loanable funds to supplement current income in order to sustain
current living standards represents what financial service area?

D)
credit services
CORRECT
Trading in securities previously issued takes place in the:

B)
secondary market

The financial system and financial markets are responsible for providing
which of the following services?
Credit services
Payment services
Liquidity
Facilitating the flow of savings
All of the above (CORRECT ANSWER)
CORRECT
A(n) _____ market exists if the market is fully competitive and the same
information is available to all participants.

C)
perfect
ECT
The role of markets in a market-oriented economy like the United States is
to:
allocate resources.
distribute income.
produce needed goods and services.
D)
all of the above.(correct)

The financial service supplied by the money and capital markets in which
financial instruments are created to attract savings for future financial needs
is called:

D)
thrift services
When different sets of information are available to different participants in
the market, we say that there is:

B)
asymmetric information
ORRECT
The circular flow of funds includes which of the following:
consumer units
households
government
D)
all of the above (correct)
CT
The ______ is designed for the making of short-term loans where individuals
and institutions with temporary surpluses of funds meet borrowers who
have temporary cash shortages.

A)
money market

The financial system determines:


the cost of credit
how much credit is available.
the prices of securities
the quantity of securities issued by borrowers
E)
all of the above.
ORRECT
To gain access to the money market an institution must:
have an excellent credit rating
be well known
be large
D)
all of the above

The largest market in the world for a single security is:

C)
the treasury bill market

A market in which competition among buyers and sellers sets the terms of
trade is a:

D)
perfect market
The financial system provides all the following services except:

C)
equitably distribute wealth
T
According to your text, a key trend in the financial system is:
increasing competition
greater risk
growth of technology
growth of debt
E)
all of the above are key trends for the financial system (CORRECT)
CORRECT
Which type of market is not part of the circular flow?

B)
Information market

Acting as an agent for a customer in managing retirement funds or other


property represents what financial service area?

hedging services
credit services
thrift services
insurance
E)
none of the above

INCORRECT
The form of market efficiency in which assets are priced efficiently based on
the past history of prices and all current assets' prices reflect fully the past
history of information about the assets to which those prices are attached is
known as: a weak form market efficiency

A)
semi-strong form efficiency

One of the financial markets listed below is not part of the nation's capital
market. Which one is not?

D)
Commercial paper market