Role of Financial Markets
Definition
Financial markets: markets that channel funds from savers to borrowers, matching those with surplus money to those who need it.
Financial intermediation: banks pooling savers' deposits and passing them on as loans, so the sector does far more than store money.
- The financial sector performs five main functions in a modern economy.
Saving and Lending
- Facilitating saving: it offers households and firms safe places to store money and earn a return, such as deposit and savings accounts.
- Lending to businesses and individuals: it turns pooled savings into loans for investment and consumption, since individual savers rarely know which firms need funds.
Payments, Forward Markets and Equities
Definition
Forward market: a market where a price for a currency or commodity is agreed today for delivery at a future date.
Equities: shares representing part-ownership of a company, issued and traded on a stock market.
- Facilitating exchange: a payments system of current accounts, cards and transfers lets buyers and sellers settle transactions quickly, and mobile money such as M-Pesa in Kenya has extended this to millions of people without a conventional bank account.
- Providing forward markets: traders can fix a future price today, so an exporter can hedge against adverse currency movements.
- Providing a market for equities: firms raise long-term capital by issuing shares while savers can buy and sell them, for example on the London Stock Exchange.
Why Intermediation Matters
- Efficient intermediation turns idle saving into productive investment, and more investment raises the economy's capacity and growth, a link captured by the Harrod-Domar model.
- A weak financial sector starves firms of the funds they need, so financial development underpins wider economic development in emerging economies.
Exam technique
- List the five roles, then focus on channelling saving into productive investment.
- Link efficient intermediation to higher investment and growth.
- Where relevant, connect financial development to economic development.
Common Mistake
- Do not treat banks as merely holders of deposits, since they are intermediaries that channel funds from savers to borrowers.
- Do not list the roles without explaining how each supports the wider economy.
Self review
- State the core role of the financial sector.
- How does the sector facilitate the exchange of goods and services?
- What is a forward market and who uses it?
- What does a market for equities allow firms to do?
- Why does intermediation support growth?
