CHAPTER

Money and Capital Markets

Functions and Roles of the Chapter 5 Financial System in the Global Economy
Prepared by: HOY Pichravuth - MBA AIT, Thailand - DEA Paris II University, France

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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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.

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)

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. 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

Financial markets Producing units (mainly business firms and governments)

Flow of funds (savings) Flow of financial services, income, and financial claims

Consuming units (mainly households)

Factor markets

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 of funds (mainly business firms and governments)

Flow of loanable funds (savings) Flow of financial services, incomes, and financial claims

Suppliers of funds (mainly households)

Saving&Investment
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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.

Liquidity (immediately spendable cash)

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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. risk-sharing and risk reduction

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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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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.

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Extra Material

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Extra Material

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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 U.S. Treasury Department at www.publicdebt.treas.gov
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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

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Saving & Investment

Saving: The amount of funds left over out of current income after current consumption expenditures are deducted or, for a business firm, the current net earning retained in the business instead of pay out to the owners. Investment: Expenditures on capital goods or on inventories of goods or raw material that are used to produce other goods and services, causing future production and income rise.

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What is Liquidity?

Liquidity is the quality or capacity of an asset to be sold quickly with little risk of loss and possessing a relatively stable price over time

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risk-sharing and risk reduction risk-sharing: occurs when an individual or institutions transfers risk exposure to someone willing to accept that risk (insurance company)
risk reduction: take place when we diversify our wealth across a wide variety of different assets so that our overall losses are likely to be more limited. (portfolio of financial assets)

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Q&A
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