Financial markets involve the trading of financial assets, such as bonds, stocks, currencies and commodities.
The key roles of financial markets are to:
- Facilitate saving
- Households can save their money in a high street bank in a saving account to earn interest.
- Current accounts also provide interest but often at lower rates than saving accounts.
- Households can also use financial markets to invest in assets such as bonds and stocks (see more on this below).
- Lend to businesses and individuals
- High street banks lend out a large proportion of the funds deposited in the bank by savers.
- This lending can go to businesses in the form of a business loans. This greater availability of loanable funds allows businesses to invest more and grow their company.
- Similarly lending can go to households, for example mortgages are a type of loan used for buying a house.
- Lending can also be used to spread the payments for cars, washing machines or other products over time. A newer type of this kind of lending is “buy now pay later” schemes, which includes companies such as Klarna.
- Bonds allow bondholders to lend to governments and corporations. In exchange, households can also earn interest payments.
- Government bonds entitle the bondholder to fixed interest payments from the government, in exchange for providing upfront funds to the government. Corporate bonds work similarly.
- Facilitate the exchange of goods and services
- To buy a good or service, the payment must flow in the opposite direction.
- Financial markets provide ways for people to make payments for goods and services.
- This could be as simple as a bank providing a bank account and instantly approving an online transaction. By providing credit and debit cards as well as online banking apps, people can transfer money instantly in exchange for receiving goods.
- Foreign exchange (forex) markets enable currencies to converted, allowing domestic residents to buy imports and foreign residents to buy exports.
- Provide forward markets for currencies and commodities
- A forward market can provide a guaranteed price at a specified future date by buying a “futures contract” (sometimes just called futures)
- For example, the ability to lock in a price for a currency transfer in one year’s time. This could be useful for firms who engage in cross-border exporting or importing.
- This can also apply to commodities (raw materials used in production) such as oil. A firm that uses oil in its production process can lock in a guaranteed price to buy oil in six months’ time.
- This allows firms to have greater certainty about their future costs. This makes firms more likely to invest.
- However those using futures contracts have to pay a fee in exchange for being able to lock in this price.
- This may increase firm costs and lead to firms overpaying for commodity inputs or currencies in some cases.
- Forward markets also give producers such as farmers a guaranteed future price for selling their goods. This makes farmers more certain about their revenue, so again farmers are more likely to invest.
- Provide a market for equities
- Equities can refer to shares.
- A share is a financial asset that gives the holder a small percentage stake in the company.
- The shareholder makes money if they buy the share for a low price and sell the share for a high price.
- The shareholder also makes money when part of the company profit is paid out directly to shareholders. This is known as a dividend payment.
- Selling shares enables companies to raise funds for investment or expansion.
- This can boost aggregate demand as investment is a component of AD.
- Higher investment also improves the quality of factors of production, increasing productivity and shifting LRAS right.
- As a result the economic growth rate rises.
We should note that these roles of financial markets can overlap. For example, providing loans to consumers to buy cars also facilitates the exchange of goods.
Banks act as an intermediary – they take savings for those who deposit money in the bank and lend them out to businesses and individuals.
Well-functioning financial markets boost investment and consumption. This leads to higher aggregate demand and higher long-run aggregate supply (as firms invest in increasing the quality and quantity of factors of production).
In practice, financial markets can fail, which can undermine (and even reverse) the impact of financial markets on the economy. I cover this more in the financial market failure section (forthcoming).
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