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Summary The Financial System and Economic Growth

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Financial System and Economic Growth

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Financial System And Economic Growth

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...

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Uploaded on July 1, 2023
Number of pages 18
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Type Summary

economics
economic growth
financial system
role of financial system

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The Financial System
The Financial and
System and
14
Economic Growth
Economic Growth

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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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