Money, Banking, and International Finance

Money and the Financial System

This chapter introduces the financial system. Students will learn the purpose of financial markets and its relationship to financial institutions. Financial institutions connect the savers to the borrowers through financial intermediation. At the heart of every financial system lies a central bank. It controls a nation’s money, and the money supply is a vital component of the economy.

Unfortunately, economists have trouble in defining money because people can convert many financial instruments into money. Thus, central banks use several definitions to measure the money supply. Furthermore, if an economy did not use money, then people would resort to an inefficient system – barter. Unfortunately, this society would produce a limited number of goods and services.

Nevertheless, money overcomes the inherent problems with a barter system and allows specialization to occur at many levels. Financial Markets Money and the financial system are intertwined and cannot be separated. They both influence and affect the whole economy, such as the inflation rate, business cycles, and interest rates. Consequently, consumers, investors, savers, and government officials would make betterinformed decisions if they understood how the financial markets and money supply influence the economy.

A financial market brings buyers and sellers face to face to buy and sell bonds, stocks, and other financial instruments.

Buyers of financial securities invest their savings, while sellers of financial securities borrow funds. A financial market could occupy a physical location like the New York Stock Exchange where buyers and sellers come face-to-face, or a market could be like NASDAQ where computer networks connect buyers and sellers together.

A financial institution links the savers and borrowers with the most common being commercial banks. For example, if you deposited $100 into your savings account, subsequently, the bank could lend this $100 to a borrower. Then the borrower pays interest to the bank. In turn, the bank would pay interest to you for using your funds. Bank’s profits reflect the difference between the interest rate charged to the borrower and the interest rate the bank pays to you for your savings account. Why would someone deposit money at a bank instead of directly buying securities through the financial markets? A bank, being a financial institution, provides three benefits to the depositor.

First, a bank collects information about borrowers and lends to borrowers with a low chance of defaulting on their loans. Thus, a bank’s specialty is to rate its borrowers. Second, the bank reduces your investment risk. Bank lends to a variety of borrowers, such as home mortgages, business loans, and credit cards. If one business bankrupts or several customers do not pay their credit cards, then the default does not financially harm the bank. Bank would earn interest income on its other investments that offset the bad loans. Finally, a bank deposit has liquidity. If people have an emergency and need money from their bank deposits, they can easily convert the bank deposit into cash quickly.

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