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.
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 better informed 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.