The Financial System: A Comprehensive Guide

Posted on Jul 31, 2024 in Economy

ITEM 1: INTRODUCTION

In today’s society, the trading of goods and services is primarily conducted through money. Economic units often find themselves needing resources at specific times. While some entities possess surplus resources, others require additional resources to function effectively. This discrepancy creates a need to connect savers, who have excess resources, with investors seeking capital. This connection is facilitated by the financial system.

CONCEPT AND CHARACTERISTICS OF THE FINANCIAL SYSTEM

The financial system acts as an intermediary between economic units with surplus resources (savers) and those with a deficit (investors). Savers generate more resources than they immediately need, while investors require more resources than they can produce at a given time. The financial system bridges this gap by capturing funds from savers and channeling them to investors.

IMPORTANCE OF THE FINANCIAL SYSTEM

The financial system plays a crucial role in the economy for several reasons:

  • Savers and investors are generally not the same entities, necessitating a mechanism to connect them.
  • The desires of savers and investors often differ. Savers seek low risk and steady returns, while investors aim for higher returns, often accepting greater risk.

Key Components of the Financial System:

  1. Institutions: Entities responsible for mediating between savers and investors, facilitating the exchange of funds. Examples include central banks, commercial banks, and regulatory bodies.
  2. Media: Instruments, services, or products offered by financial intermediaries to facilitate the transfer of funds from savers to investors. These can include loans, bonds, and stocks.
  3. Markets: Platforms where financial intermediaries buy and sell financial assets, determining their prices based on supply and demand. Examples include stock exchanges and bond markets.

MONETARY POLICY

Monetary policy, a key aspect of economic policy, aims to control inflation and promote employment. Inflation, a continuous and widespread increase in the general price level, is typically measured using the Consumer Price Index (CPI).

To manage inflation and employment, monetary authorities can influence:

  1. Interest Rates: The cost of borrowing money.
  2. Reserve Requirements: The proportion of funds banks must hold in reserve, limiting their lending capacity.

Economic Scenarios and Monetary Policy Responses:

  1. High Inflation: Requires a tight monetary policy, potentially involving increased interest rates and reserve requirements to curb spending and control inflation.
  2. High Unemployment: Necessitates a loose monetary policy, potentially involving lower interest rates and reduced reserve requirements to encourage borrowing, investment, and job creation.

7. EUROPEAN CENTRAL BANK (ECB)

The European Central Bank (ECB) is the central bank for the Eurozone, responsible for the monetary policy of the euro currency. Established in 1998 and headquartered in Frankfurt, Germany, the ECB’s primary mission is to maintain price stability within the Eurozone.

Bodies of the ECB:

  1. Governing Council: The ECB’s supreme decision-making body, responsible for formulating monetary policy for the Eurozone and setting key interest rates.
  2. Executive Board: Implements monetary policy as defined by the Governing Council and manages the day-to-day operations of the ECB.
  3. General Council: Facilitates the integration of all European Union countries into the Eurosystem.

8. THE BANK OF SPAIN

The Bank of Spain, as part of the Eurosystem, contributes to the implementation of the ECB’s monetary policy within Spain. It also plays a crucial role in ensuring the stability of the Spanish financial system.

8.1 Governing Bodies of the Bank of Spain:

  1. Governor: The highest authority within the Bank of Spain, appointed by the King of Spain upon the proposal of the Prime Minister. The Governor serves an eight-year term and is responsible for the bank’s overall direction.
  2. Deputy Governor: Appointed by the government on the proposal of the Governor, the Deputy Governor serves an eight-year term and assumes the Governor’s responsibilities in their absence.
  3. Governing Council: Comprises the Governor, Deputy Governor, six appointed members, the Director General of the Treasury and Financial Policy, and the Vice-Chair of the National Securities Market Commission (CNMV). The Governing Council approves the bank’s general policies, including those related to monetary policy.
  4. Executive Committee: Consists of the Deputy Governor and two appointed members. The Executive Committee formulates and implements policies related to credit institutions and makes recommendations for enforcement actions.

8.2 Functions of the Bank of Spain:

  • Implement the EU’s monetary policy within Spain.
  • Conduct foreign exchange operations.
  • Promote the smooth operation of payment systems.
  • Issue legal tender coins.
  • Hold and manage foreign reserves.
  • Supervise the solvency and behavior of credit institutions.
  • Promote the stability of the financial system.
  • Put coins into circulation.
  • Produce and publish statistics related to its duties.
  • Assist the ECB in collecting statistical information.
  • Manage treasury and public debt.
  • Advise the government on economic and financial matters.

9. FINANCIAL INTERMEDIARIES

Financial intermediaries are the backbone of the financial system, connecting savers and investors and significantly reducing the costs associated with direct transactions between the two parties. They provide a range of services, including:

9.1 Bank Financial Intermediaries:

These institutions, such as banks, savings banks, credit unions, and credit institutions, engage in fundraising operations and are creators of money through lending activities.

9.2 Non-Bank Financial Intermediaries:

These intermediaries, including securities firms and insurance companies, facilitate the flow of capital between savers and investors but do not have the power to create money.

9.3 Functions of Financial Intermediaries:

  • Mediation between savers and investors.
  • Facilitation of economic growth.
  • Risk reduction through diversification.
  • Profit maximization for both savers and investors.
  • Streamlining of financial operations.
  • Reduction of transaction costs.

10. FINANCIAL MARKETS

Financial markets are platforms where financial assets, such as stocks and bonds, are traded, and their prices are determined by the forces of supply and demand. Examples include stock exchanges, bond markets, and commodity markets. With advancements in technology, physical locations are becoming less critical, with online platforms and electronic trading systems gaining prominence.

10.1 Functions of Financial Markets:

  • Connect buyers and sellers of financial assets.
  • Reduce intermediation costs and transaction times.
  • Determine prices of financial assets based on supply and demand.
  • Provide liquidity, allowing investors to easily buy and sell assets.

11. FINANCIAL ASSETS

Financial assets represent claims on future cash flows or ownership in an entity. They allow individuals and institutions to move resources from the present to the future, typically with the expectation of earning a return. However, this transfer of resources over time involves uncertainty and risk, requiring compensation in the form of potential returns.

11.1 Characteristics of Financial Assets:

Yield: performance k we obtain x k capital delivery is made and the k risk assumed. likidez: usually star in reverse to profitability, how much more having an active likidez usually less profitable.risk: the possibility of getting lost in an investment, the higher risk higher return.