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.

A well-functioning financial system helps people reduce their exposure to risks. An example of a well-functioning financial system can be seen as if the owner of a business expects to make a greater profit if they purchase additional capital equipment but isn’t completely sure of this result.

A business owner can reduce the risk of loss by diversifying assets, investing in a variety of assets with unrelated (or independent) hazards.

• The term loan refers to a lending agreement between an individual lender and an individual borrower.

Loan-backed securities are traded on financial markets in a similar manner to bonds. This is because they are appealing to investors because they provide more diversification and liquidity than loans do.

A family might also invest their present resources or riches by acquiring a physical asset, which is a claim on a real thing such as an existing house or piece of equipment. It allows the owner to dispose of the thing how he or she sees fit (for example, rent it or sell it).

An asset is considered to be liquid if it cannot be converted into cash without loss of a larger value. Whereas, an asset is considered to be illiquid if it can be converted to cash quickly without much loss of financial value.

Each category of an asset provides a different use in macroeconomic models.

Transaction costs, financial risk, and the demand for liquidity are the three major issues confronting borrowers and lenders. A financial system's three tasks are to solve these issues in a cost-effective manner. This improves financial market efficiency by increasing the likelihood of mutually advantageous transactions between lenders and borrowers—trades that enrich society.

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.