Function of financial markets

Salvador Domingos

Salvador Domingos

Financial Controller at Nampak Bevcan Angola/ CIMA Document In Business Bookkeeping

Financial markets perform the essential economic function of channeling funds from households, firms, and governments that take saved surplus funds past spending less than their income to those that have a shortage of funds because they wish to spend more than their income. This function is shown schematically in Figure below. Those who have saved and are lending funds, the lender-savers, are at the left, and those who must borrow funds to finance their spending, the borrower-spenders, are at the right. The primary lender-savers are households, but business enterprises and the regime (particularly state and local government), as well every bit foreigners and their governments, sometimes also find themselves with excess funds and and so lend them out.

The near important borrower-spenders are businesses and the government (particularly the federal government), but households and foreigners also borrow to finance their purchases of cars, article of furniture, and houses. The arrows show that funds menstruation from lender-savers to borrower-spenders via 2 routes.

In directly finance (the route at the bottom of Figure 1), borrowers borrow funds direct from lenders in financial markets by selling them securities (also chosen financial instruments), which are claims on the borrower's time to come income or assets. Securities are assets for the person who buys them but liabilities (IOUs or debts) for the individual or firm that sells (problems) them. For example, if General Motors needs to borrow funds to pay for a new factory to manufacture electric cars, it might borrow the funds from savers by selling them bonds, debt securities that hope to make payments periodically for a specified catamenia of time. Why is this channeling of funds from savers to spenders so important to the economy? The answer is that the people who relieve are frequently non the same people who have profitable investment opportunities available to them, the entrepreneurs. Allow's starting time recollect about this on a personal level. Suppose that you have saved $1,000 this year, only no borrowing or lending is possible considering in that location are no financial markets. If you do not have an investment opportunity that volition permit you to earn income with your savings, you will merely concord on to the $ane,000 and will earn no interest. All the same, Carl the Carpenter has a productive utilize for your $1,000: He can apply it to buy a new tool that will shorten the fourth dimension it takes him to build a house, thereby earning an extra $200 per twelvemonth. If you could get in bear on with Carl, you could lend him the $1,000 at a rental fee (interest) of $100 per yr, and both of yous would be amend off. You would earn $100 per year on your $1,000, instead of the zip amount that you would earn otherwise, while Carl would earn $100 more income per year (the $200 actress earnings per yr minus the $100 rental fee for the use of the funds).

In the absenteeism of financial markets, you lot and Carl the Carpenter might never assemble. Without financial markets, it is difficult to transfer funds from a person who has no investment opportunities to one who has them; you would both be stuck with the status quo, and both of you would be worse off. Financial markets are thus essential to promoting economical efficiency.

The existence of financial markets is too beneficial even if someone borrows for a purpose other than increasing product in a business. Say that you are recently married, accept a good job, and want to buy a house. You earn a good bacon, but because you lot have just started to work, you accept not yet saved much. Over time, you would have no problem saving enough to buy the business firm of your dreams, just by and so you lot would exist likewise old to go full enjoyment from it. Without fiscal markets, you are stuck; you cannot purchase the house and must continue to alive in your tiny flat. If a financial market were fix then that people who had congenital upward savings could lend you lot the funds to buy the house, you would be more than happy to pay them some interest in guild to own a habitation while you are still immature enough to relish information technology. So, over fourth dimension, you would pay back your loan. The overall outcome would be such that you would be better off, as would the persons who made you the loan. They would now earn some involvement, whereas they would not if the financial market did not exist.

Now we tin see why financial markets accept such an important role in the economic system. They allow funds to movement from people who lack productive investment opportunities to people who have such opportunities. Thus financial markets are critical for producing an efficient allocation of capital, which contributes to college product and efficiency for the overall economy. Indeed, every bit nosotros will explore, when financial markets break downwards during financial crises, as they have in Mexico, East asia, and Argentina in recent years, severe economical hardship results, which can even pb to dangerous political instability. Well-functioning financial markets also directly improve the well-being of consumers by allowing them to time their purchases improve. They provide funds to young people to buy what they need and tin can eventually afford without forcing them to look until they have saved up the entire purchase price. Financial markets that are operating efficiently improve the economic welfare of everyone in the lodge.

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