Activities in the Financial System:
There are two major activities in the financial system. i) Savings ii) Investments
Savings: Saving units are households (mainly), businesses and the government.
1. Household Savings: What is left from the current income after current expenditure and tax payments.
Household Savings = Current Income-Tax Payments-Consumption Expenditures
2. Business Savings: The current retained earnings after payment of taxes and shareholder dividends.
3. Government Savings: Government savings are the surplus of current revenues over current expenditures in the government budget.
Investments: Investments are made by business firms (mainly), households and the government.
- Business firms make investments for the acquisition of buildings and equipments, the purchase of raw materials for producing goods and services, the purchase of finished goods for resale.
- The government makes investments to create and maintain public facilities like the construction of bridges, buildings, highways, hospitals, schools, colleges, universities etc.
- Households make investments for the purchase of home, automobiles etc.
Savers invest their current income to earn more return in the future. The financial market enables the exchange of current income for more future income. Through the financial market, transformation of savings into investments occur. Through the financial system, funds flow from suppliers to demanders.
Demanders require a huge amount of funds for investments to produce goods and services demanded by consumers. Funds may be raised by selling stocks and bonds in the financial market to households, businesses and the government. And the suppliers of funds receive only promises in return for the loan of their money in the form of dividends of stocks, interests on bonds and deposits and claims on insurance policies. The suppliers of funds expect to earn additional income as a reward for waiting and assuming risk and to recover the original funds.
Functions of the Financial System:
There are some specific functions of the financial system. The functions are:
1. Savings Functions 2. Wealth Functions 3. Liquidity Functions 4. Credit Functions 5. Payment Functions 6. Risk Protection Functions 7. Policy Functions
1. Savings Functions: Financial market provides profitable and relatively low risk outlet for the public savings. It offers various types of deposit schemes and insurance policies. These savings are used to invest in financial instruments such as stocks, bonds, treasury bills and other securities that are sold in the financial market. Savings flow through the financial system into investments so that more goods and services can be produced and more employment opportunities can be generated.
2. Wealth Functions: Wealth is the accumulated savings build up over time. Financial market preserves the value of financial assets. For example, if the money is stored in things, it subjects to depreciation and carries greater risk of loss. But bonds, stocks and other financial instruments do not wear out over time and generate income.
3. Liquidity Functions: Financial markets provide liquidity for savers who hold financial instruments but are in need of money. Holders of financial assets/instruments can easily convert into money through the financial market.
4. Credit Functions: Financial markets provide credit to finance consumption and investment spending. Consumers need credit to purchase home, automobiles, to buy groceries, to retire outstanding debts. Businesses use credit to build inventory, to meet payrolls, to give dividend to shareholders, to construct additional facilities. Government borrows from the financial market to construct public facilities and to meet daily cash expenses.
5. Payment Functions: Financial system provides mechanism for making payments for goods and services. The popular medium for exchange in making payments: currency, non-interest bearing checking account (current accounts), interest bearing checking accounts (saving accounts), debit cards (customers can pay immediately by debiting automatically in his/her account in a depository institution), credit cards (customers can access to short time credit for the purchase of goods and services)
6. Risk Protection Functions: Financial markets offer businesses, consumers and the government protection against life, health, property and income risks. There are two major types of institutions that offer protection: i) Life insurance companies ii) Property casualty insurance companies. Life insurance companies offer policies against possible loss of income following the death of individuals. Property casualty insurance companies protect policy holders against health and damages of property.
7. Policy Functions: Financial markets are a channel through which government stabilize the economy and avoid inflation. Government can affect the borrowing and spending plans of the public by manipulating interest rates and the availability of credit.
Flow of savings (loanable funds)
Demanders of Funds
Suppliers of Funds
Flow of financial claims (interest, dividends etc.)
