Financial markets and intermediaries
How the financial system connects savers with borrowers through bonds, stocks, banks and funds, and the accounting that ties saving to investment.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Tell financial markets from financial intermediaries
- Describe what affects a bond's interest rate
- Use S = I and split national saving into private and public saving
Builds toward: Invest on your own. Understand low-cost funds, read a fund factsheet, and spot a sales pitch.
The economy behind your investments: lesson 1 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 13
What it is
The financial system is the set of institutions that match one person's saving with another's investment. Mankiw divides it in two.
Financial markets let savers lend directly to borrowers:
- The bond market. A bond is a certificate of debt: an IOU that says when the loan will be repaid (the date of maturity) and the interest paid until then. Three features affect its interest rate: 1. Term: long-term bonds usually pay more, because the holder waits longer to get the money back. 2. Credit risk: the chance the borrower defaults. Safe borrowers such as the US government pay low rates; shaky firms issue high-interest junk bonds. Agencies such as Standard & Poor's rate this risk. 3. Tax treatment: in the US, interest on state and local government bonds (municipal bonds) is free of federal income tax, so they pay lower rates than comparable taxable bonds.
- The stock market. A share (stock) is part ownership of a firm and a claim on its profits. Share prices reflect what people expect about future profits. The price–earnings ratio (P/E) compares the price with earnings per share; Mankiw notes that historically the typical P/E has been about 15.
Financial intermediaries stand between savers and borrowers:
- Banks take deposits and make loans, charging borrowers slightly more than they pay depositors. They also provide a medium of exchange: deposits people can spend by card or cheque.
- Mutual funds sell shares to the public and buy a portfolio of stocks, bonds or both. They make diversification easy. Mankiw notes that index funds, which buy every stock in an index, have on average done somewhat better than actively managed funds, because their costs are lower.
Quick check
Tap an answer to check it.
A small shop borrows from its local bank to expand. Is this direct or indirect finance?
- Direct finance means selling bonds or shares to savers in a financial market
Show answer
Indirect: the bank is a financial intermediary between savers and the shop. The savers' deposits reach the shop through the bank.
Why it matters
Saving equals investment. Take a closed economy (no trade with other countries), so Y = C + I + G. Then:
- National saving S = Y − C − G: the income left after consumption and government purchases. So S = I: for the economy as a whole, saving equals investment.
- With taxes T, national saving splits into private saving (Y − T − C: what households keep after taxes and consumption) and public saving (T − G: what the government has left after its spending).
- If T > G, the government runs a budget surplus and public saving is positive. If G > T, it runs a budget deficit, and public saving is negative.
The identity S = I is always true for the whole economy, but it doesn't say how saving and investment are brought into line. That is the job of the financial system, modelled in the next lesson as the market for loanable funds.
A word on "investment". In everyday speech, buying shares is "investing". In macroeconomics, investment means buying new capital, such as equipment or buildings; buying shares is saving.
Worked example
A closed economy (in billions): GDP 10, consumption 6.5, government purchases 2, taxes 1.5.
- National saving: S = 10 − 6.5 − 2 = 1.5.
- Private saving: 10 − 1.5 − 6.5 = 2.
- Public saving: 1.5 − 2 = −0.5 (a budget deficit of 0.5).
- Check: 2 + (−0.5) = 1.5. And investment must equal saving: I = 1.5.
Common mistake
Calling a share purchase "investment" in the macroeconomic sense. When you buy a share, you save. Only if the firm is selling new shares does it get the use of your money, and only if it spends that on new capital is there investment: the purchase of new capital goods, such as a factory or machine.
Key terms
- financial system
- the institutions that help match one person's saving with another's investment
- financial markets
- institutions through which savers can lend directly to borrowers
- financial intermediaries
- institutions through which savers lend to borrowers indirectly
- bond
- a certificate of debt
- stock (share)
- a claim to partial ownership in a firm
- mutual fund
- an institution that sells shares to the public and uses the money to buy a portfolio of stocks and bonds
- national saving
- income left after consumption and government purchases
- private saving
- income households have left after taxes and consumption
- public saving
- tax revenue the government has left after its spending
- budget deficit
- government spending greater than tax revenue
Practise the key terms
Tap a card to turn it over. 10 cards.
| Front | Back |
|---|---|
| financial system | the institutions that help match one person's saving with another's investment |
| financial markets | institutions through which savers can lend directly to borrowers |
| financial intermediaries | institutions through which savers lend to borrowers indirectly |
| bond | a certificate of debt |
| stock (share) | a claim to partial ownership in a firm |
| mutual fund | an institution that sells shares to the public and uses the money to buy a portfolio of stocks and bonds |
| national saving | income left after consumption and government purchases |
| private saving | income households have left after taxes and consumption |
| public saving | tax revenue the government has left after its spending |
| budget deficit | government spending greater than tax revenue |
Practice
Work it through
A closed economy: GDP 20, consumption 13, government purchases 5, taxes 4.
- 20 − 13 − 5
- 20 − 4 − 13
- 4 − 5
- In a closed economy, investment equals national saving
Sort it
Which group does this belong to?
A company sells new bonds to the public
Savers lend to the company directlyShow answer
Financial market. Savers lend to the company directly
A bank lends a family's deposits to a builder
The bank stands between saver and borrowerShow answer
Financial intermediary. The bank stands between saver and borrower
A fund buys shares in 500 companies with savers' money
A mutual fundShow answer
Financial intermediary. A mutual fund
A firm sells new shares on the stock exchange
Direct financeShow answer
Financial market. Direct finance
Quick quiz
Tap an answer to check it.
Why do municipal bonds in the US usually pay lower interest than corporate bonds?
- Mankiw's reason is their tax treatment
Show answer
Their interest is free of federal income tax. Tax-free interest is worth more, so buyers accept a lower rate.
When does the government run a budget deficit?
- A deficit means public saving is negative
Show answer
When its spending is greater than its tax revenue. G > T makes public saving negative.
In short
- Financial markets (bonds, stocks) let savers lend directly; intermediaries (banks, funds) stand between.
- A bond's rate depends on its term, credit risk and tax treatment.
- In a closed economy, S = I; national saving = private saving + public saving.
- A budget deficit is negative public saving.
Mastery check
Answer without looking back. Score 80% or more and the lesson is marked done. Your result is kept only in this browser.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
Name the three features of a bond that affect its interest rate.
Show answer
Its term, its credit risk and its tax treatment.
What is the typical historical P/E ratio, according to Mankiw?
Show answer
About 15.
In the worked example, what is public saving?
Show answer
−0.5: a budget deficit of 0.5.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 13.
- On this site: The market for loanable funds.
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