1.4Summary

A nancial system consists of a set of organised markets and institutions together

with regulators of those markets and institutions. Their main function is to channel

funds between end users of the system: from lenders (‘surplus units’) to borrowers

(‘decit units’). In addition, a nancial system provides payments facilities, a variety

of services such as insurance, pensions and foreign exchange, together with facilities

which allow people to adjust their existing wealth portfolios.

There are many advantages in borrowing and lending via intermediaries and

organised markets, compared with borrowing and lending directly between end-users.

These include transforming the maturity of short-term savings into longer-term loans,

together with the reduction of risk and transaction costs.

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Chapter 1 • Introduction: the nancial system

Questions for discussion

1	List the functions of a nancial system.
2	Distinguish between decit and surplus units.
3	Distinguish between ‘saving’ and a ‘nancial surplus’.

4	Discuss the advantages to decit and surplus units of using organised nancial markets and nancial intermediaries.

5	How are nancial intermediaries able to engage in maturity transformation?

6	Explain briey the difference between deposit-taking and non-deposit-taking inter- mediaries. Give two examples of each.

7	Why do people simultaneously hold nancial assets and liabilities?

8	Imagine that a household has a £50,000 mortgage on which its bank currently charges 7 per cent p.a. Suppose that it also has £8,000 in a deposit account which pays 3 per cent p.a. What does this tell you about the value which this household places upon liquidity?

9	Suggest a suitable asset for someone who wished to avoid the following types of risk at all cost: (a) capital risk; (b) income risk.

Further reading

AD Bain, The Financial System(Oxford: Blackwell, 2e, 1992) ch. 1

M Buckle and J Thompson, The UK Financial System(Manchester: Manchester UP, 4e, 2004)

chs. 1 and 2

R Glenn Hubbard, Money,The Financial System and the Economy(Reading MA: Addison-

Wesley, 3e, 2004)

SI Greenbaum and AV Thakor, Contemporary Financial Intermediation(Dryden, 1995)

chs. 2 and 3

PG A Howells and K Bain, The Economics of Money, Banking and Finance(Harlow: Financial

Times Prentice Hall, 3e, 2005) chs. 1 and 2

DS Kidwell, RL Peterson and D Blackwell, Financial Institutions, Markets and Money

(London: Dryden Press, 6e, 1997)

FS Mishkin, The Economics of Money, Banking and Financial Markets(Pearson Addison-

Wesley, 7e, 2004) ch. 2

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CHAPTER2

The nancial system and

the real economy

Objectives

What you will learn in this chapter:

lHow nancial surpluses and decits arise out of real economic activity

lHow a nancial surplus affects the stock of wealth

l	How developments in the nancial system may affect the level of aggregate demand

l	How developments in the nancial system may affect the composition of aggregate demand

l	How developments in the nancial system may affect the allocation of resources

In this chapter we are concerned with the relationship between the nancial system

and what is sometimes called the ‘real’ economy. The ‘real’ economy consists of rms,

households and other agencies engaged in the production of goods and services

which can either be consumed now or put to use with a view to producing more in

future. We think of this as ‘real’ economic activity because it is using real resources

to produce something which people can buy and use, whereas the nancial system

is mainly concerned either with moving funds around so that those who wish to buy

can do so, or with helping people to exchange ownership of the productive resources.

The words that we use are chosen obviously to suggest that the activities of the real

economy are essential to life. The real economy produces food, heating, lighting,

consumer goods, entertainment. The job of the nancial system is to facilitate that

by making sure that funds are available when and where they are wanted.

This is a reasonable view, so far as it goes. However, there is a danger that we see

the nancial system as providing a service which merely responds to the demands

of the real economy. But this is only one side of the picture. There are many ways

in which the behaviour of the nancial system affects the behaviour of the real

economy. Just think of the way that people respond to stock market booms (by

feeling richer and spending more) and to stock market slumps (by hoarding their

incomes and cancelling spending plans). Causality works in both ways. The real

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Chapter 2 • The nancial system and the real economy

economy generates nancial activity by employing people (who wish to save some

of their income) in rms (which wish to borrow for investment purposes).

In the rest of this chapter we look at just four examples (there are many more)

of how the real economy and the nancial system interact. In the next section, we

look at how the real economy generates nancial surpluses and decits which the

nancial system has to reconcile. In the remaining sections we turn the tables and

look at how features of the nancial system may affect the real economy. We look

at three issues. The rst two are concerned with the size and development of the

nancial system. The third is concerned with the efciency with which the nancial

system does its job. In section 2.2 we look at how the nancial system may create

liquidity or even money, which may in turn affect the level of aggregate spending in

the economy. In section 2.3 we consider ways in which the existence of a nancial

system may affect the composition of total spending in the economy – it may

encourage less consumption and more spending on capital goods. In section 2.4

we look at how the performance of the nancial system may affect the allocation of

resources, in particular funds for investment and management expertise.