6.12 The financial sector: summary and overview

what’s necessary to smooth consumption

being able to borrow and save .

does everyone rely on investment?

yes - even if they don’t invest themselves, our incomes come from companies who are working with assets they’ve invested in

what is the role of the financial sector in the economy

to make borrowing, saving, and investing possible - or at least more efficient and effective than it would otherwise be

**financial sector provides foundation for debt and money which are necessary for a modern economy, allows households to invest more than they would be able to directly

disagreements about financial sector

(1) some economist think debt is good for consumption smoothing, diversification, and efficient use of savings, argue that fluctuations in prices of assets in financial markets show signals that increase ecnoomic efficiency

(2) some economists argue for light touch of financial sector

(3) other think about frequent recurrence of financial and debt crises and how the financial sector reinforces existing wealth inequality - without substantial regulation, financial systems are unstable and subject to costly booms and busts

advantages of debt

(1) allows ppl to consume before they have income

(2) allows borrowers to invest in productive assets therefore increasing future output

(3) lenders can have future payments

(4) currency and bank money = means of exchange

(5) base money = gov debt = means of exchange and unit of account

(6) debt incentivizes firms to find the most productive forms of capital

disadvantages of debt

(1) commitments to pay debt are fixed - can’t back out

(2) returns are risky

(3) if you’re a lender someone may default

(4) bank money means possibility for bank runs

(5) currency value is eroded by inflation = poor store of value

bank advantages

(1) reduce risk of lending on their assets through diversification

(2) provide specialist lending to certain types of borrowers

(3) liabilities are a store of value

(4) banks provide means of exchange

(5) financial assets allow households to invest indirectly

(6) better to lend to a bank than a person bc diversification

bank disadvantages

(1) always some non-diversifiable risk

(2) often offer poor returns at long horizons due to inflation

(3) bank runs

financial market advantages

• bond markets allow govs and corps to borrow directly from investors

• pension funds allows households to save for retirement during working life, can reduce risk through diversification

• stock market returns are risky but have higher returns typically not affected by infaltion rates

• financial assets i.e. bonds and shares allow households to invest indirectly in forms of productive capital they couldn’t invest in directly

financial market disadvantages

bond prices are snesitive to changes in IR = risky returns over SR

risk of default

most pension funds invest in risky assets

a good amount of non-diversifiable risk in stock market