Chapter 2
Overview of the
Financial System

Chapter Preview
• Suppose you want to start a business manufacturing a household cleaning robot, but you have no funds.
• At the same time, Walter has money he wishes to invest for his retirement.
• If the two of you could get together, perhaps both of your needs can be met.
But how does that happen?
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Chapter Preview
• As simple as this example is, it highlights the importance of financial markets and financial intermediaries in our economy.
• We need to acquire an understanding of their general structure and operation before we can appreciate their role in our economy. Copyright © 2009 Pearson Prentice Hall. All rights reserved.

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Chapter Preview
• In this chapter, we examine the role of the financial system in an advanced economy. We study the effects of financial markets and institutions on the economy, and look at their general structure and operations. Topics include:
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Function of Financial Markets
Structure of Financial Markets
Internationalization of Financial Markets
Function of Financial Intermediaries
Financial Intermediaries
Regulation of the Financial System

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Function of Financial Markets
• Channels funds from person or business without investment opportunities (i.e.,
“Lender-Savers”) to one who has them (i.e.,
“Borrower-Spenders”)
• Improves economic efficiency

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Financial Markets Funds Transferees
Lender-Savers

Borrower-Spenders

1. Households

1. Business firms

2. Business firms

2. Government

3. Government

3. Households

4. Foreigners

4. Foreigners

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Segments of Financial Markets
1. Direct Finance
• Borrowers borrow directly from lenders in financial markets by selling financial instruments which are claims on the borrower’s future income or assets

2. Indirect Finance
• Borrowers borrow indirectly from lenders via financial intermediaries (established to source both loanable funds and loan opportunities) by issuing financial instruments which are claims on the borrower’s future income or assets

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Function of Financial Markets

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Importance of Financial Markets
• This is important. For example, if you save
$1,000, but there are no financial markets, then you can earn no return on this – might as well put the money under your mattress.
• However, if a carpenter could use that money to buy a new saw (increasing her productivity), then she’d be willing to pay you some interest for the use of the funds.
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Importance of Financial Markets
• Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack productive investment opportunities to people who have them.
• Financial markets also improve the wellbeing of consumers, allowing them to time their purchases better.
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Structure of Financial Markets
It helps to define financial markets along a variety of dimensions (not necessarily mutually exclusive). For starters, …

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Structure of Financial Markets
1. Debt Markets
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Short-Term (maturity < 1 year)
Long-Term (maturity > 10 year)
Intermediate term (maturity in-between)
Represented $41 trillion at the end of 2007.

2. Equity Markets
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Pay dividends, in theory forever
Represents an ownership claim in the firm
Total value of all U.S. equity was $18 trillion at the end of 2005.

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Structure of Financial Markets
1. Primary