The Role of the Financial System
Households and firms with surplus funds to invest require access to productive investment opportunities in new businesses, products, and ideas. How does society match up those with surplus funds to others with viable investment opportunities who need funds? And how...
The Financial System
The Financial and
System and
14
Economic Growth
Economic Growth
Preview
Quite understandably, ordinary people (and many economists) underestimate the
importance of the financial system. What, after all, do investment bankers and other
finance workers produce to deserve such towering salaries and bonuses, sometimes in
the millions of dollars? Why did the government rescue financial firms during the
2007–2009 financial crisis at great expense, while leaving businesses in other indus-
tries to fail?
We examine the role that the financial system plays in the economy in this and the
following chapter. This chapter focuses on the long run, that is, on what role the financial
system plays in promoting economic growth. It discusses why a well-functioning finan-
cial system is a key condition for high economic growth. The following chapter focuses
on the short run, that is, it looks at what happens when the financial system suddenly
stops working well, which can cause a sharp contraction in economic activity.
We start this chapter by first outlining the financial system’s role in channeling
funds in the economy. Then, we describe the two kinds of information problems that
can interfere with the flow of funds in the financial system, and the role of banks and
governments in resolving those problems. The tools that we develop to conduct this
analysis will also be building blocks for the discussion of financial crises in the follow-
ing chapter. Finally, we review the empirical evidence of a link between a well-
functioning financial system and a healthy economy.
The Role of the Financial System
Households and firms with surplus funds to invest require access to productive invest-
ment opportunities in new businesses, products, and ideas. How does society match up
those with surplus funds to others with viable investment opportunities who need
345
,346 PART FIVE • FINANCE AND THE MACROECONOMY
funds? And how does society ensure that funds are channeled to worthwhile invest-
ment opportunities, so as to not squander the resources?
Enter the financial system, which can act as the brain of the economy by per-
forming the essential coordinating function of channeling funds from households
and firms with surplus funds to those individuals and firms with both a shortage
of funds and productive investment opportunities. A well-functioning financial sys-
tem directs funds to where they can do the most good, promoting economic stabil-
ity and growth.
Channeling funds efficiently through the financial system is a complex task, as
illustrated by the schematic diagram in Figure 14.1. Lender-savers—those with
excess funds to invest—are at the left and borrower-spenders with productive
investment opportunities are at the right: funds move between these two parties via
two main conduits.
Direct Finance
One way that funds move directly from lender-savers (investors) to borrower-
spenders via financial markets is the direct financeroute shown at the bottom of
Figure 14.1. With direct finance, borrowers borrow funds directly from savers via
FIGURE 14.1
Flow of Funds INDIRECT FINANCE
Through the
Financial System
Direct finance, the FUNDS Financial FUNDS
route shown at the bot- Intermediaries
tom, involves borrow-
ers borrowing funds
directly from savers.
FUNDS
Indirect finance, in
which financial inter-
mediaries stand
between savers and
borrowers, is more cir-
cuitous and operates
through two different Lender-Savers Borrower-Savers
routes: 1) where finan- 1. Households Financial 1. Business firms
2. Business firms FUNDS FUNDS 2. Government
cial intermediaries Markets
3. Government 3. Households
obtain funds from 4. Foreigners 4. Foreigners
savers and then use
them to make loans to
borrowers (the arrows DIRECT FINANCE
at the top of the figure),
and 2) where financial
intermediaries use the
funds from savers to
purchase securities
issued by borrowers
(shown by the arrow
from financial interme-
diaries to financial
markets).
, CHAPTER 14 • THE FINANCIAL SYSTEM AND ECONOMIC GROWTH 347
financial markets by selling them securities (also called financial instruments ),
which are claims on the borrowers’ future income or assets in the form of common
stock or bonds. Securities are assets for the firm or person who buys them, but they
are liabilities (IOUs or debts) for the individual or firm that sells (issues) them. For
example, if a textile company in Malaysia needs to borrow funds to pay for a new
factory to produce shirts, it might seek funds from U.S. investors by selling them
equities , like common stock that represents a share of ownership of a corporation,
or bonds , debt securities that offer a stream of payments for a fixed period of time.
Financial institutions engaged in direct finance facilitate transactions in financial
markets. These include exchanges , where buyers and sellers of securities (or their
agents or brokers) meet in one central location to conduct trades, or investment
banks that both trade securities and help corporations issue securities by guaran-
teeing a price for the securities and then selling them.
Indirect Finance
Most funds are channeled to borrowers through the circuitous indirect financeroute
shown at the top of Figure 14.1. With indirect finance, a financial intermediary —a
type of financial institution such as a bank, insurance company, finance company,
mutual fund, or pension fund—stands between lender-savers and borrower-
spenders, as the top part of Figure 14.1 indicates. (Descriptions of the types of finan-
cial intermediaries can be found in the box, “Financial Intermediaries.”) In other
words, a financial intermediary acts as an intermediarybetween lender-savers and
borrower-spenders. For example a bank obtains funds from savers by issuing
deposits and then uses these funds to make loans, say for a young couple to buy a
house. Another example is an insurance company that obtains funds by issuing insur-
ance policies and collecting premiums, and then makes loans to a corporation to build
a hotel.
A second way financial intermediaries can stand between lender-savers and
borrower-spenders is described by the route depicted in Figure 14.1 by the arrow that
shows funds flowing from financial intermediaries to financial markets, and then from
financial markets to borrower spenders. For example, a mutual fund obtains funds
from investors and then uses these funds to purchase securities such as common stocks
in the financial markets. Another example is a pension fund that receives funds from
employees and their employer and then buys securities such as bonds in the financial
markets. This process of linking borrower-spenders and lender-savers through financial
intermediaries is called financial intermediation .
Most borrowers in advanced countries obtain credit through financial intermedia-
tion. Financial intermediaries are a more important source of financing for businesses
than securities markets, supplying close to 60% of the funds flowing to nonfinancial
businesses. Most bonds and about half of all stocks are purchased by financial interme-
diaries in financial markets (the downward arrow in Figure 14.1).
In developing countries where stock and bond markets are often tiny or nonexistent,
almost all lending is done through financial intermediation. In these places, households
and firms borrow through rural moneylenders, savings and credit associations, family
networks, or programs for microcredit , which offer very small loans, often less than $100.
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