This chapter examines how the financial system works. First, we discuss the large variety of institutions that make up the financial system in our economy. Second, we discuss the relationship between the financial system and some key macroeconomic variables notably saving and investment. Third, we develop a model of the supply and demand for funds in financial markets. | 26 Saving, Investment, and the Financial System The Financial System The financial system consists of the group of institutions in the economy that help to match one person’s saving with another person’s investment. It moves the economy’s scarce resources from savers to borrowers. FINANCIAL INSTITUTIONS IN THE . ECONOMY The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. Financial institutions can be grouped into two different categories: financial markets and financial intermediaries. FINANCIAL INSTITUTIONS IN THE . ECONOMY Financial Markets Stock Market Bond Market Financial Intermediaries Banks Mutual Funds FINANCIAL INSTITUTIONS IN THE . ECONOMY Financial markets are the institutions through which savers can directly provide funds to borrowers. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Financial Markets The Bond Market A bond is a . | 26 Saving, Investment, and the Financial System The Financial System The financial system consists of the group of institutions in the economy that help to match one person’s saving with another person’s investment. It moves the economy’s scarce resources from savers to borrowers. FINANCIAL INSTITUTIONS IN THE . ECONOMY The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. Financial institutions can be grouped into two different categories: financial markets and financial intermediaries. FINANCIAL INSTITUTIONS IN THE . ECONOMY Financial Markets Stock Market Bond Market Financial Intermediaries Banks Mutual Funds FINANCIAL INSTITUTIONS IN THE . ECONOMY Financial markets are the institutions through which savers can directly provide funds to borrowers. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers. Financial Markets The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. Characteristics of a Bond Term: The length of time until the bond matures. Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. Tax Treatment: The way in which the tax laws treat the interest on the bond. Municipal bonds are federal tax exempt. IOU Financial Markets The Stock Market Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. The sale of stock to raise money is called equity financing. Compared to bonds, stocks offer both higher risk and potentially higher returns. The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ. Financial Markets The Stock Market Most newspaper stock tables provide the following information: Price (of a share) Volume (number of shares sold) Dividend (profits paid to stockholders) .
