The purpose of financial markets

Financial assets exist in an economy because the savings of various individuals, corporations, and governments during a period of time differ from their investment in real assets. By real assets, we mean such thing as houses, buildings, equipment, inventories, and durable goods. If savings equaled investment in real assets for all economic units in an economy over all periods of time, there would be no external financing, no financial assets, and money or capital markets. Each economic unit would be self-sufficient.

Current expenditures and investment in real assets would be paid for out of current income. A financial asset is created only when the investment of an economic unit in real assets exceeds its savings and it finances this excess by borrowing or issuing stock. Of course, another economic unit must be willing lend.

This interaction of borrowers with lenders determines interest rates. In the economy as a whole, savings-surplus units those whose savings exceed their investment to real assets provide funds to savings deficit units (those whose investments in real assets exceed their savings). This exchange of funds is evidenced by investment instruments, or securities, representing financial assets to the holders and financial liabilities to the issuers.

The purpose of financial markets in an economy is to allocate savings efficiently to ultimate users. If those economic units that saved were the same as those that engaged in capital formation, an economy could prosper without financial markets. In modern economies, however, most non-financial corporations use more than their total savings for investing in real assets.

Most households, on the other hand, have total savings in excess of total investment. Efficiency entails bringing the ultimate investor in real assets and the ultimate saver together at the least possible cost and inconvenience.

Financial Markets:

Financial markets are not so much physical places as they are mechanisms for channeling savings to the ultimate investors in real assets. The role of financial markets and financial institutions

in moving funds from the saving sector (savings-surplus units) to the investment sector (savings-deficit units). From the prominent position held by certain financial institutions in channeling the flow of funds in the economy, the secondary market, financial intermediaries, and financial brokers are the key institutions that enhance funds flows.