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1
4
CHAPTER I
AN OVERVIEW OF THE FINANCIAL SYSTEM
omy are satisfied by their interaction. This book focuses primarily on financial
markets, for it is in these markets that financial institutions, savers, and investors
.come togerlrer to~t
~ehttnges offinanGi.1.in£truments.
The financial market.
place is the core of the financial system.
The purpose of this chapter is to develop an overview of the role, structure,
and operation of the financial system. In addition, a brief discussion of this
book.s organization
and content is included.
THE ROLE OF THE FINANCIAL
,
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,
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:
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~
SYSTEM
f.~onomic activity is characterized by many exchange transactions-the
buying and selling of goods, services, and productive resources. Economists often
find useful a distinction between the "real" and "financial" aspects of these transactions. In a sales transaction, for example, a buyer takes physical possession of
goods in exchange for a payment of money or a promise to pay in the future.
The former aspect of the transaction is "real"; the latter is "financial:' The goods
are "real assets"; the payment is with a "financial asset." In a barter system, goods
are exchanged for goods; the introduction of money as a medium of exchange
adds the "financial"
element to economic transactions.
As the "real" aspects of transactions become more complex, involving ex.
changes over time as well as at a point in time, their "financial" aspects necessar.
ily become more involved. The "real" aspect of a loan, for example, is the postponement by the lender of the opportunity to consume now (buy something with
the funds instead of lending them) with the expectation of consuming more in
the future. The "financial"
aspect of a loan involves the creation of a financial
instrument, which may range from an IOU between friends, through the execu.
tion of a bank note indicating due date, interest, and so on, to the rather complex
process of the issuing of debt securities by a corporation.
There are important relationships between the financial system of the domestic and international economy and the enormously varied and complex activities of individuals and businesses working, buying, and selling as part of the
ordinary course of human affairs. The financial system includes both markets for
financial instruments and those institutions that are concerned with financial
transactions, just as the "real" component of the economic system includes both
markets for goods and services and those institutions that bring together people
and resources to produce goods and services. The financial system is a vital component of the total economic system, greatly increasing its capacity to satisfy the
needs and wants of individuals for goods.
The economic role of the financial system can be mainly characterized as one
of facilitating real and financial transactions. Figure 1.1 depicts the relationship
between the financial system and the various real and financial flows in the economy. In this simplified view the economic system consists of a business sector, a
,
THE ROLE OF THE FINANCIAL SYSTEM
5
Financial
obligations
Financial
assets
Borrowedfunds
"-'
tinveStm~
The financial systcm
(markets,instruments.
Payments
1iiiBjiistlrunons)-for goodsandservices
loaned funds
(~avtngsr
Goodsandservices
Tax
payments
Business
sector
Tax
p:lyments
Government
services
Government
sector
Government
services
Ifousehold
sel;tor
Productiveinputs(labor,etc.)
Paymentsfor inputs(wages,sal:lries,
etc.)
FIGUREJ-J, ExchangeFlows in an Economic System
-',
"
,
household ~ector, and a government sec(Or. In ternlS of real flows, the business
sector produces goods and seryices, which are purchased by the household sector
for consumption purpc)ses. The household sec(Or provides labor and c)ther necessary productive inputs (0 the business seCtor ill exchange for wages, salaries, and
other compensation. (We shall say more about these "other" inputs and compen.
sation shortly.) The go\'cmment sector collects tax payments from the household
and business sectors and uses these receipts to blty goods, sen'ices, and productive inputs, which are then used to supply govemment services (roads, law enforcement, and so on) to the other sectors,l
Turning to the role of the financial system (other than the payments function) in this simple model of the economy. we may note that the financial system
is interposed between flows of saving, investment, and financial instruments (financial assets of savers and financial obligations of investors). We may note further that these flows reflect exchanges of resource use over time, rather than
exchanges of real resources at points in time ("spot" exchanges). Exchanges of
resource use over time (lending and borrowing) is made possible by some economic participants' forgoing current consumption in favor of future consumption. This postponement of consumpti?n~saving-is
encoltraged by the prospect that future consumption opportunities
will be enlarged as the result of the
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'For the sakeof simplicit).,Fig. 1,1 assumesa "balancedbudget" in the governmentsect()r.
.\ctuallv,()f c()urse,the go"ernment secu.ris a freyuem participant in financialmark~s.
burro"ing funds by
. issuingfinancial obligations,
6
CHAPTER I
productive
AN OVERVIEW OF THE FINANCIAL SYSTEM
use of the resources currently
made available for investment
pur-
poses.2
The existence of saving in an economic system provides an opportunity
for
.theb1:lstn~s~ seaor 'tOe-x.panttlhe means ofproauttion.
In a private enterprise
economy, households can use saved receipts to lend to business firms or to purchase ownership shares in business firms. Such transfers of purchasing power
supply the business sector with money capital, the financial resources that enable
firms to gather and use real resources for investmenrand thereby increase output
of goods and services. The investment of these funds in turn provides the means
of paying a return on savings-interest
in the case of loaned funds and dividends
in the case of purchases of ownership shares. The now of saved resources to the
business and government sectors from the household sector is a productive input
into :~bese sector5, just as is labor. Jnterest and dividends are the compensation
for this flow of saved resources, just as wages are the compensation for labor
provided. (These are the "other" inputs and compensation mentioned previ-
\,
ously.)
Economic units, whether in the household, busine5s, or government sector,
that spend less than their net receipts are called surplus economic units. This
'- ..excess
of net receipts over expenditures for a period of time is called saving
when it occurs in the household sector, retained earnings in the business sector,
and a budget surplus in the government sector. (The term "saving" is used for
all instances of surplus receipts in the following discussion.) An economic unit
in an;y of tht:: economy's sectors may also elect (voluntarily or involuntarily)
to
spend more than its net receipts by drawing on past saving (dissaving) or by
borrowing. These economic units are called deficit economic units. Dissaving is
made possible by the conversion of past saved funds into currently spendable
funds.
The financial system-the
framework of instruments, markets, and institu.
tions-facilitates
the transfer of saved funds from surplus (savers) to deficit
spending units (borrowers).:! A deficit spending unit may borrow from a surplus
unit by exchanging a financial instrument (a promise to make future payments)
for the latter's saved funds. The issuer of the instrument (the borrower) thus
incurs a financial obligation. The recipient of the instrument (the lender) obtains
a financial asset. Such exchanges of saved funds for financial assets are readily
and efficiently accomplished in financial markets. The important contribution
to this process made by the third component of the financial system-financial
'Saving is a flow, an amount for some period of time equal to the difference between two other
flows for that period: income and consumption spending. Savinp is a stock, the accumulated
quantity of saved funds at a point in time.
'A deficit spending unit need not be a borrower if it has saved resourcesfrom prior periods. In
this case,dissaving is possible by expending these saved resources.If. as is likely. the saved
resources are held in the form of financial instruments. they can be readily converted into money
for spending purposes.
I
I
lent purunity for
nterprise
.>rto purng power
tat enable
.se output
d ea d
ns
~I.e,men s
ulVl
'ces to the
tive input
pensation
for labor
Iled previ-
SAVING, INVESTMENT, AND FINANCIAL MARKETS
I
d
led saving
less sector,
is used for
]omic unit
mtarily) to
.ing) or by
)issaving is
spendable
md instituI to deficit
n a surplus
: payments)
ri)Wer) thus
jeT) obtains
are readily
ontribution
I-financial
--other
11two other
umulated
h h
.
I
.
d..
institutions-Is
ma e t roug t elr ro e as mterme larles between Ienders and
~orrowers. The financial intermediation process is of great significance for the
channeling of saved T1:in-asirito investment uses. Financial intermediation
involves financial instrument creation and acquisition and financial market activities, as well as financial institutions, and warrants some additional introductory
discussion.
I'
SAVING, INVESTMENT,
I
AND FINANCIAL
MARKETS
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'.
ent sector,
.nits. This
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Fundamental to understanding the role of financial markets in the economy
is some-understanding
of saving and investment. Decisions to save and invest
strongly influence the level of employment, production, and income. Moreover,
the long-term economic growth of a society depends on the saving and investments habits of its population. It is often argued that the relatively rapid economic growth rate in japan in recent years reflects the high rate of saving and
investment in that country.
S
.
avrng
Saving refers to the act of postponing current consumption, that is, of consuming' less tlian current income. As such, saving is sometimes referred to as
abstinence-abstaining
from using all of one's current income to purchase goods
and services. Saving releases resources for the consumption of other economic
units or for investment by the saver or others. It is in saving for investment purposes that the act of saving has its paramount economic significance. Through
investment an economy both broadens and deepens its productive capacity. Investment involves the business sector expanding its equipment and other productive facilities and financing inventories as production expands.
The decision to save-to postpone current consumption-and
the decision
about where to place these savings-a savings account, Treasury securities, stocks,
or other types of financial assets-are quite distinct and fundamentally different
decisions. The decision to save is essentially nonfinancial in nature and depends
on the individual's preference for present consumption compared with future
consumption and on the real (inflation-adjusted) return expected on that saving.
In contrast, the decision to add to a savings account, buy stocks, or purchase
types of financial ass~ts is a financial transaction determined by the relative
return/risk characteristics of the different assets." It is the former decision-to
postpone current consumption-that
makes resources available for investment
purposes and thus is essential for economic growth.
'The savinghabits of individuals tend to be relativelystable,but the particulartype of financial
outlet for savingsshifts substantiallyasrelativerateson different financialinstrumentschange-
8
CHAPTER I
AN OVERVIEW OF THE FINANCIAL SYSTEM
Investment
"
Investment TeTers to the acquisition of new productive equipment, buildings,
and inventory-that
is, the purchase of real assets. Such increases in capital are
a means of expanding the productive capacity of an economy. Economic growth
is fundamentally
dependent on investment. Increases in real productive assets
add to the output capacity of the economy and can be achieved only in conjunction with the act of saving. Real resources can be used to expand the capital base
of the economy only if those real resources are not being used to produce consumer goods. In contrast, buying common stock or bonds does not add directly
to the quantity of equipment and plant.
'];;ne foregoing discussion is not meant to imply that transactions in the financial markets are unimportant.
Indeed, much of this book is devoted to explaining
why these financial transactions are important to economic stability and growth.
But it is necessary to note the crucial distinction between real investment and
the acquisition of financial instruments. Throughout this chapter. unless otherwi~ noted, the term "investment" will refer to the purchase of real assets, such
as plant, equipment, and inventory.
The Importance
.
of Saving and Investment
The volume of saving and investment is important from at least two perspectives- First, the amount of saving and investment has a profound impact on the
economic growth potential of an economy- Although economic growth is a complex issue involving social, political, and cultural characteristics of nations, as
weD as the availability of natural resources and various other economic factors,
one of the most significant influences is investment. Additions to plant and
equipment incorporating
new technology and other types of investment are at
the base of an expanding economy. It is no accident that nations that devote a
large proportion of their resources to investment also tend to have rapid economic growth- Such investment cannot occur without saving. Many observers
view the relatively slow growth in productivity in the United States in recent years
as attributable to policies that have encouraged consumption at the expense of
saving and discouraged productivity-expanding
investment.
Saving and investment are also important because of their influences on economic stability and the business cycle. The balance between the amount that
people desire to save and the amount that they wish to invest is a basic factor
affet:ting the short-run economic stability of the economy. If the volume of desired saving (ex ante) exceeds the volume of desired investment (ex ante), there
will be insufficient demand.for the total output of the economy. As a result, production will be cut, income and employment will fall, and indeed, actual saving
will decline. (The Great Depression of the 1930s has been explained by some
scholars as resulting from an excess of desired saving compared with desired
.
9
c,
goods and services.
luce con-
investment.) In contrast, if desired investment exceeds desired saving, there will
be an excessive amount of demand for the current level of output.5 At output
levels at which substantial amounts of unused labor and capital resources are
available, the result of the imbalance of desired investment over desired saving
is an expansion in total output. As the economy comes closer to full employment
of resources, however, the result is in~reases in prices for goods and services.
Ultimately, at the point at which no further resources are available, the excess of
idesired"jnvestment
simply results in higher prices for a constant quantity of
tildings,
pital are
" gt-owth
ve assets
conjunc}ital base
:1 directly
-
he ~n~n"plalnmg
l\ growth.
Inent and
ess other,~ets, such
u perspecla~t on the
I h IS.a com~
natIons, as
mic factor~
, plant an
ment are at
tat d~vote a
.rapId eco,y observers
f
,'ecent years
expense 0
"fhis discussionis in termsof desiredor I'XantI'savingand investment,After the fac(,realizedor
I'X/HIstsavingand investmentmustbe equal.Changesin pfl,duction and income that occur as the
result of the differencesin desiredsavingand investmentproduce the equalityex postbetween
.
savingand Investment.
"This doesnot meanthat businessdoesnot save.nur does it meanthat individualsdu nut invest,
Obviously.through the act of retainingearnings.businesssavesa substantialamuunt. and through
their purchaseof homesand other real assets.individuals investlargesums.But un balance.
huuseholdssavemore than theyinvest.and businesses
invest Inure than theysave.Furthennore.
(he governmentsectormust be included.althuughlIver a lung periud. guvernmentvariesffllm
d b y some
d red
.
.
wIth
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FINANCIAL
INTERMEDIATION
'" "
Our discussion of financial intermediation has focused so far on the nature
of saving and investment and their importance. The relationship of financial
markets to the saving and investment process stems from an important aspect of
this process: saving and investing in most advanced economies are done by different groups. Mo'st saving is done by individuals (households), and most investing
is done by business.1i As a result, individuals provide funds to business to hire
labor and capital and expand the productive capacity of the economy. But there
must be some mechanism by which saved funds (which represent released real
resources) are made available to those who need the funds (command over real
resources) to accomplish their investment goals. This mechanism is provided by
the financial marketplace.
Table 1.1 provides lists of the major participants and instruments in the.
saving-investment
process. At the core of the process are the basic economic'
sectors of our economy: business, government (federal, state, and local), and t
households. These economic sectors are connected with one another, and saving
is channeled to investment through the financial system, often through the intermediating function of financial institutions. For example, households may deposit saved funds with a commercial bank, savings and loan association. or other
similar type of financial institution. The command over real resources that these
funds represent is thus transferred to the financial institution, and the individual
,Ices on eCO- ,
,mount th~"
b .factor
aSIC f de--..
,Iume 0
ante), tliere
t result, prolctual saving
Ie
b
'
.
emg a net saverto a net Investor.
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