Markets

The great importance of the financial system in our daily lives can

be illustrated by reviewing its different functions. There are seven basic

functions of the financial system in a modern economy.

Savings Function. As we noted earlier, the system of financial mar-

kets and institutions provides a conduit for the public’s savings. Bonds,

stocks, deposits, and other financial claims sold in the money and capi-

tal markets provide a profitable, relatively low-risk outlet for the public’s

savings. Those savings flow through the financial markets into invest-

ment so that more goods and services can be produced in the future,

increasing society’s standard of living. When savings flows decline, how-

ever, the growth of investment and living standards begin to fall.

Wealth Function. For those businesses and individuals choosing to

save, the financial instruments sold in the money and capital markets

provide an excellent way to store wealth (i.e., to preserve value) until

funds are needed for spending in future periods. While we might choose

to store our wealth in “things” (e.g., automobiles and clothes), such

items are subject to depreciation and often carry great risk of loss. How-

ever, bonds, stocks, and other financial instruments do not wear out over

time and usually generate income; and, normally, the risk of loss is much

less than for other forms of stored wealth.

Liquidity Function. For wealth that is stored in financial instruments,

the financial marketplace provides a means of converting those instru-

ments into ready cash with little risk of loss. Thus, the financial system

provides liquidity for savers holding financial instruments but in need

of money. In modern societies money consists mainly of deposits held

in banks and is the only financial instrument possessing perfect liquid-

ity. Money can be spent as it is without the necessity of converting it

into some other form. However, money generally earns the lowest rate

of return of all assets traded in the financial system, and its purchasing

power is seriously eroded by inflation. That is why savers generally mini-

mize their holdings of money and hold other financial instruments until

spendable funds really are needed.

Credit Function. In addition to facilitating the flow of savings into in-

vestment and providing liquidity for stored wealth, the financial markets

furnish credit to finance consumption and investment spending. Credit

consists of a loan of funds in return for a promise of future payment.

Consumers frequently need credit to purchase a home, buy groceries,

repair the family automobile, and retire outstanding debt. Businesses

draw upon their lines of credit to stock their shelves, construct buildings,

meet payrolls, and grant dividends to their stockholders. State, local,

and federal governments frequently borrow to construct buildings and

other public facilities and cover daily cash expenses until tax revenues

flow in.

Payments Function. The financial system also provides a mechanism

for making payments for goods and services. Certain financial assets,

mainly checking accounts and negotiable order of withdrawal (NOW)

accounts, serve as a medium of exchange in the making of payments.

Plastic credit cards issued by many banks, credit unions, and retail stores

give the customer instant access to short-term credit but also are widely

accepted as a convenient means of payment. Plastic cards and electronic

means of payment, including computer terminals in homes, offices, and

stores, are likely to displace checks and other pieces of paper as the prin-

cipal means of payment in the years ahead.

Risk Function. The financial markets offer businesses, consumers,

and governments protection against life, health, property, and income

risks. This is accomplished first of all by the sale of life and property-ca-

sualty insurance policies. Policies marketed by life insurance companies

indemnify a family against possible loss of income following the death

of a loved one. Property-casualty insurers protect their policyholders

against an incredibly wide array of personal and property risks ranging

from ill health, crime, and storm damage to negligence on the high-

ways. In addition to making possible the selling of insurance policies, the

money and capital markets have been used increasingly by businesses

and consumers to “self-insure” against risk. This simply means building

up one’s holdings of securities, deposits, and so forth, as a precaution

against future loss.

Policy Function. Finally, in recent decades the financial markets have

been the principal channel through which government has carried out

its policy of attempting to stabilize the economy and avoid excessive in-

flation.

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