Transaction costs, financial risk, and the desire for liquidity are the three major issues that borrowers and lenders face.
A financial system's three tasks are to decrease these issues in a cost-effective manner. This improves the efficiency of financial markets by increasing the likelihood of mutually advantageous trades between lenders and borrowers of which such trades benefit society as a whole.
The term transaction costs refer to the expenses of executing a deal and any of the steps associated with the process.
The term financial risk refers to the uncertainty about future outcomes that incorporate financial gains and losses.
It's crucial to remember that a dollar created by national savings and a dollar generated by capital inflow is not the same thing on a national level. Yes, they can both fund the same dollar in investment expenditure, but any dollar borrowed from a saver must be returned with interest at some point. A dollar borrowed from national savings is returned to a domestic borrower with interest.
A dollar that comes in as a capital inflow, on the other hand, must be repaid to a foreigner with interest. As a result, a dollar of investment expenditure funded by a capital inflow has a greater national cost than a dollar of investment spending financed by national savings (due to the interest that must eventually be paid to a foreigner). As a result, an economy that is open to inflows has an investment spending identity.
That is, in a positive capital inflow economy, some investment expenditure is financed by foreigners' savings. Furthermore, in a negative capital inflow (net outflow) economy, a portion of national savings is used to support investment spending in other nations.
Financial risk, or uncertainty about future events that entail financial losses or profits, is an issue that real-world borrowers and lenders encounter. Financial risk (which we'll refer to as "risk" from now on) is a concern because the future is unknown; it has the potential for both losses and benefits.
The majority of people, to varying degrees, are risk-averse. People may decrease their risk exposure by having a well-functioning financial system.
Although larger companies may create room to buy stocks, small business owners and smaller companies sell shares of their stock. This is because they are considered to be “privately held” by an individual or a group of a few people, which is often not associated with a larger group to ensure security and to ensure that not many people are directly benefiting from the company’s profit.
We have stocks and a stock market because people want to decrease their overall risk by diversifying their investments. The financial system's final job is to offer liquidity to investors, which, like risk, becomes important when the future is unclear.
The money market is in equilibrium at the interest rate rE: the quantity of money demanded by the public is equal to M, which is the quantity of money supplied.