The financial system is one of the most important inventions of modern industrial societies. Its vital task is to move scarce loanable funds in the form of credit from those who save to those who borrow for consumption and investment. By making funds available for lending and borrowing, the financial system provides the means whereby modern economies grow and increase the standard of living enjoyed by their citizens.
Much of the creidt thus obtained goes to purchase machinery and equipment, to construct new bridges, highways, factories, and schools, and to stock the shelves of business with inventories of goods. Without the financial system and the credit it supplies, each of us would lead a very different and probably less enjoyable existence.
The financial system determines both the cost of credit and how much credit will be available to pay for the thousands of different goods and services we purchase daily. Equally important, what happens on this system has a powerful impact upon the health of the nation's economy. When credit becomes more costly and less available, total spending for goods and services generally falls. As a result, unemployment rises, and the economy's growth slows down as businesses cut back production and reduce inventories. In contrast, when the cost of credit declines and loanable funds become more readily available, total spending in the economy usually increases, more jobs are created, and the economy' s rate of growth accelerates. In truth, the financial system is an intergral part of the economic system and cannot be viewed in isolation from it.
Investment in new equipment increases the productivity of labor and ultimately leads to a higher standard of living. However, investment generally require large amount of funds, often far beyond the resources available to a single firm or government unit. By selling financial claims - stocks, bonds, etc. - in the financial markets, though, large amounts of funds can be raised quickly, and the loan repaid out of future income. Indeed, the financial markets operating within the nation's financial system make possible the exchange of current income for future income.
Those who supply funds in the financial markets receive only promises in return for the loan of their money. These promises are packaged in the form of attractive claims and financial services - stocks, bonds, checking accounts, savings deposits, insurance policies, etc. . Financial claims promise the supplier of funds a future flow of money income, which may consists of dividends, interest payments, capital gains, or other returns. Of course there is no guarantee that the expected flow of future income will ever materialize. However, suppliers of funds to the financial system expect not only to recover their original commitment of funds but also to earn additional income as a reward for waiting and for the assumption of risk. The role of the financial markets in channeling savings into investment is absolutely essential to the health and vitality of the economic system.
