Financial System Definitions: Study with Video Lessons, Practice Problems & Examples

The financial system connects households that save money with firms that need funds for long-term investments. Households invest in financial securities like stocks and bonds, while firms use these funds to acquire capital goods, enhancing future production. The system reduces transaction costs, mitigates financial risk through diversification, and provides liquidity, allowing assets to be easily converted to cash. Financial intermediaries, such as mutual funds, facilitate these transactions, making it simpler for firms to raise capital and for households to invest.

Financial System Definitions

Alright. So now let's learn some details about the financial system and let's start off with a few key definitions. We're going to be talking about in the next few videos the financial system. This is the idea that there are households that are saving some of their money. In general, households save some of their money while firms need money to invest in long-term assets. So the money that households are saving is being invested by firms. They're going to borrow that money and invest it, okay? The financial system is the group of markets where these firms are acquiring funds from savers. So the households are saving money and the firms are borrowing that money to invest, right? Financial markets, when we talk about the group of financial markets, well, there are tons of different financial markets, and I'm sure you've heard of some of them. Markets for purchase and sale of financial securities such as stocks and bonds, right? When we think about a firm selling stock to the public or selling bonds to the public, well, this happens in financial markets, right? This is exactly what happens. The firms are going to be selling securities. So this is how financial markets work. The firm sells a security to the household. So the household now has this financial investment, right? This security is a financial investment for the household, and then the household gives cash, right? Cash to the firm, and the firm needs that to make investments in, say, long-term assets like a new factory, machinery, things like that, right? So the financial market facilitates that. It gives the firms the ability to sell things to the household, these securities to the household to raise cash, right? So they can have cash. When we talk about investment in this class, just like we just said, the household makes an investment in these securities; well, that's a financial investment. When we talk about investment specifically in economics, financial investments are economic investments, and that deals with this definition here. Current resources are devoted to increasing future output, right? We've talked about this before. So when we talk about the term investment, well, there are 2 types of investments, right? Financial investments and economic investments. Our focus mostly in this course is on economic investments, but they do like to talk about financial investments as well. So these are generally made by households, "financial investments". And I'm going to put that in quotations here "households" because yes, firms can also buy stock and bonds of other firms, right? But in general, the idea here is that the households are making these investments; stocks and bonds are the most common financial investments compared to economic investments that are made by firms. So firms are the ones who buy factories, machinery, right? These long-term assets. I'll put LT Assets that they use to grow their business to increase future production, right? Just like we have in our definition, current resources devoted to increasing future production. So they're taking some of their resources now and devoting it to building a factory. Well, they're not going to increase production now. They're building a factory that will increase production in the future, okay? So that's generally what we're talking about when we talk about investment in this class and in the future videos coming up, okay? Just like we have up here, this financial market that we showed up here, well sometimes it's not directly that the firms are directly selling a security to the households. Sometimes, there's what's called financial intermediaries that we have right here, financial intermediaries and these are firms that act as a middleman. So, instead of let's say, Apple selling stock directly to you, well, there could be an intermediary, some sort of investment bank or some sort of mutual fund in the middle that makes the process a little easier of raising the money and selling the securities. So I'm going to draw a little diagram down here where we have a little space here. So we might have something like this. I'll do it down here. So we'll have firms and then in the middle, we'll have the intermediary, and then over here, households. I'm going to put h h for households. Right? So the firm here, sells securities. I'll put securities instead of sell. So security goes from the intermediary to the firm or, excuse me. The firm sells, let's say their stock. The firm of Apple stock gets bought by the intermediary. Let's say a mutual fund and the intermediary gives them the cash. So there we go. The firm is able to get the cash right away. Right? But now what the intermediary does is it sells, let's say stocks in the mutual fund. So the mutual fund. So now instead of buying shares in Apple stock, you might buy shares in this mutual fund of a bunch of different stocks together. And now you bought instead of a share of Apple, you bought a share of a mutual fund. And that mutual fund constitutes a lot of different types of shares. We'll talk a little bit more about mutual funds in the future, but this is the idea of a financial intermediary. So now notice, the intermediary is able to make the movement of the cash more rapid because they're able to buy the securities and give the cash immediately to the firm rather than finding household buyers while the intermediary is going to take care of that. The intermediary can now advertise their mutual fund and sell the mutual fund and raise that cash back here, right? So they'll make some money on fees or whatever they charge, to make money for facilitating this. Cool? So that's what the financial intermediary does. They're basically this middleman between the firm and the household that facilitates the movement of the cash. Let's take a quick pause here and we'll talk about these three goals that the financial system accomplishes.

Role of the Financial System

Alright, so let's talk about these main goals of the financial system. Why do we have a financial system? What does it accomplish? So the first one here is reducing transaction costs. The transaction cost is basically the cost of negotiating a deal. Okay? So think about a firm that's trying to raise $1,000,000,000. They're trying to raise $1,000,000,000. It's probably going to be very difficult to find one person who's like, "Here's $1,000,000,000, go do what you will," right? That's a lot of risk for one person to take on. However, the business could, instead of finding an individual investor, sell $1,000 bonds, right? And maybe now investors are more likely to invest by just investing $1,000. They can find a lot of people who are willing to invest $1,000 rather than one person that's willing to invest a $1,000,000,000, right? So a bond market makes it easier for a firm to raise large amounts of money because they can find lots of individual investors willing to put in smaller amounts, right? So there's a lower transaction cost rather than trying to find 1 person, they're probably going to have to go through a lot of trouble finding 1 person or if there wasn't even a bond market where you can easily put your bond out there to find investors, well, that would also make it difficult. You'd have to call everyone and be like, "Hey, do you want to buy a $1,000 bond?" Hey, no, there's a bond market where this information is easily accessible. So it reduces those transaction costs.

Next, it reduces financial risk. So when we talk about risk in this class, risk has to do with uncertainty. And when we talk about financial risk, well, it's uncertainty about the future gains or losses. So anytime we think about risk, it's because we're uncertain about the future. What is going to happen? We're not totally sure, right? So that adds risk because we're not totally sure. So financial risk is uncertainty about making money or losing money. What's going to happen? So we can reduce our financial risk by diversifying. I'm sure you've heard this word before, diversifying your investments. If you have a bunch of different investments, well there's less of a chance that they're all going to do some they're all going to lose money, right? Some will gain money, some will lose money and you diversify some of that risk away, right? Another thing you can do is buy insurance, right? That's another way you can reduce your risk, is by insuring against those losses. Cool? So the financial system allows those types of things to happen. You're able to buy a bunch of different investments. You're able to buy insurance.

Thanks to the financial system and finally, it provides liquidity. When you do have an investment, you want to be able to sell that investment whenever you're ready to sell it, right? Just because you have a share of stock, well, you don't want to be stuck with it, right? At some point, you might need the cash, and you want to be able to sell it. So liquidity is the idea of being able to convert a financial asset to cash. So you're going to have some sort of asset like in our example you own 10 shares of Apple stock, but you need cash. The financial system makes it easy to sell that stock. There's a readily available price for that stock. If you want to sell it, well, you put it on the market. You don't even need to know the person buying it from you. You just put it on the market and someone's going to buy it, right? So instead of having to call everybody you know, "Hey, do you want to buy my shares of Apple stock?" No. There's a readily available financial market and you're able to sell that stock. So it provides liquidity. It makes it so you can make these investments and you can disinvest as easily as you can invest. Right? So those are the three main goals here: Reducing transaction cost, reducing risk, and providing liquidity.

Here’s what students ask on this topic:

What is the role of financial intermediaries in the financial system?

Financial intermediaries, such as mutual funds and investment banks, act as middlemen between firms and households. They facilitate the movement of funds by buying securities from firms and selling them to households. This process helps firms raise capital more efficiently and provides households with investment opportunities. For example, instead of Apple selling stock directly to individuals, a mutual fund can buy the stock and then sell shares of the mutual fund to households. This reduces transaction costs and speeds up the flow of funds, making the financial system more efficient.

How does the financial system reduce transaction costs?

The financial system reduces transaction costs by providing organized markets where securities can be easily bought and sold. For instance, a firm looking to raise $1 billion can issue $1,000 bonds, making it easier to find multiple investors willing to invest smaller amounts. This is more efficient than finding a single investor for the entire amount. Financial markets also centralize information, making it easier for buyers and sellers to find each other, thus lowering the costs associated with negotiating and executing financial transactions.

What are the main goals of the financial system?

The main goals of the financial system are to reduce transaction costs, mitigate financial risk, and provide liquidity. Reducing transaction costs involves making it easier and cheaper to buy and sell financial securities. Mitigating financial risk is achieved through diversification and insurance, which help spread and manage uncertainty about future gains or losses. Providing liquidity means ensuring that financial assets can be easily converted to cash, allowing investors to sell their investments whenever they need to access their funds.

What is the difference between financial investments and economic investments?

Financial investments involve purchasing financial securities like stocks and bonds, typically made by households. These investments provide funds to firms but do not directly increase production capacity. Economic investments, on the other hand, are made by firms and involve acquiring long-term assets like factories and machinery. These investments use current resources to increase future production, directly contributing to economic growth. While financial investments facilitate the flow of funds, economic investments focus on enhancing productive capacity.

How does the financial system provide liquidity?

The financial system provides liquidity by ensuring that financial assets can be easily converted to cash. Organized financial markets, such as stock exchanges, allow investors to buy and sell securities quickly and efficiently. This means that if you own shares of stock and need cash, you can sell your shares on the market without having to find a buyer yourself. The availability of a market price and the presence of many buyers and sellers make it easy to convert investments into cash, providing the liquidity that investors need.