Question

How does Financial System Coordinate Saving and Investment? Explain in detail.

Answer 1

A financial system can be defined as a complex network of institutions, markets, and instruments that facilitate the flow of credit and funds in the economy. The financial system exists at the local, national, and global levels. It facilitates the transformation of assets and liabilities and maturities. This system helps in the flow of finance from the deficit areas to areas where they are in surplus. These funds can be used for consumption or investment purposes. Like other industries, the financial system can function through the market mechanism, central mechanism or through a mix of both. In this system, borrowers, investors, and lenders are involved in the exchange of some form of money.

The coordination between saving and investment takes place in the market for loanable funds. Loanable funds can be defined as the part of income that is not consumed and can be used for lending or investing. In the market for loanable funds, the equilibrium is achieved through the intersection of demand for loanable funds and the supply of loanable funds. The demand for loanable funds comes from those individuals or entities who need are in deficit for funds and need funds for investment. The supply of loanable funds comes from those individuals who possess surplus funds.

The interest rate serves as the price of funds. It is the cost of borrowing funds for the borrower and it is the return earned from lending for the lender. The market for loanable funds operates as other markets.

The equilibrium rate of interest is determined through the intersection of the demand curve and the supply curve for loanable funds. The demand for loanable funds is a downward sloping curve indicating more will be borrowed at a lower interest rate. The supply curve, on the other hand, is an upward sloping curve indicating more funds will be supplied at a higher interest rate. The equilibrium interest rate is r and the equilibrium level of investment is I.

The supply of loanable funds can come in the form of deposits in commercial banks, purchase of stocks in the capital market, or purchase of bonds. The demand for loanable funds comes in the form of borrowing from banks or the issue of securities in the market.

A financial system has several components such as financial markets, financial institutions, financial markets, and financial instruments. This system acts as a link or bridge between the individuals and entities that require funds and those who possess surplus funds. This system facilitates the capital formation and efficient allocation of funds.