moneyandbanking2009i.docVIP

Money and Banking 2009 I The Financial Sector: an Overview All economic units can be classified into one of the following groups: households, business firms, and governments. Each economic unit must operate within a budget constraint imposed by its total income for the period, and can have one of three possible budget positions: a balanced budget position, a surplus position, and a deficit position. The mismatch between income and spending for individuals and organizations creates an opportunity to trade. The financial system provides channels to transfer funds from savers (or lenders) to borrowers. Financial markets issue claims on individual borrowers directly to savers (direct financing). Financial institutions or intermediaries act as go-betweens by holding a portfolio of assets and issuing claims based on that portfolio to savers (indirect financing). This matching process makes households and businesses better off by allowing them to plan their purchases and savings according to their needs and desires, which improves the economy’s efficiency and people’s economic welfare. The financial system provides three key services for savers and borrowers: risk-sharing, liquidity, and information. First, since individuals prefer stable returns on the assets they hold. Investors tend to hold a collection of assets (portfolio) which overall provides a relatively stable returns (diversification). The financial system provides risk-sharing by allowing savers to hold many assets. Second, an asset is more liquid if it can be easily exchanged for money to purchase other assets or exchanged for goods and services. Financial markets and intermediaries provide trading systems for making financial assets more liquid. Third, one of the most prominent frictions in the financial markets is asymmetric information. Financial markets institutions and intermediaries produce useful information of potential borrowers to investors. 1 Direct vs. Indirect Financing 1.1 Dir