Overview: Financial Markets

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Markets are interrelated, and a problem in one market can have its source in a different market. This finding is a starting point for macroeconomics. To limit the number of markets they must explore, economists conventionally lump together or aggregate the vast number of markets in a modern economy into only four: markets for goods and services, financial assets, money balances, and resources.

The examination of these four aggregated markets is central to macroeconomics. Macroeconomists ask two questions as they examine each: "Is this market a likely source of instability that shows up as inflation or recession," and "Will the adjustment process in this market cause problems for the overall adjustment of the economy."

This group of readings begins our exploration of aggregated markets by looking at financial markets. We begin by introducing basic concepts of financial markets, continue by examining the role of speculators in financial markets and introducing the concept of efficient markets, and finish in the foreign exchange market, explaining the difference between floating and fixed exchange rates.

Changes in one part of the economy are rapidly transmitted to other parts through financial markets. The ability of financial markets to transmit is highlighted in the market for foreign exchange, where we show that a tariff designed to protect jobs in one part of the economy can cost jobs in other parts. Such transmission is not limited to questions of tariffs or to the market for foreign exchange; all financial markets transmit.

From a microeconomic point of view, the primary purpose of financial markets is to allocate available savings to the most productive use. A well-functioning financial sector increases economic growth. If an economy does not allocate savings to the most productive uses, it will grow more slowly than it can grow. Since we are looking at financial markets from the viewpoint of macroeconomics, this group of readings largely ignores the importance of financial markets in allocating funds.

After you complete this unit, you should be able to:
  • List some of the major financial markets.
  • Name some of the government agencies that are involved in financial markets and tell what they do.
  • Distinguish between the federal funds rate, the prime rate, and the discount rate.
  • Name some common financial intermediaries.
  • Give two reasons that savers use financial intermediaries.
  • Define liquidity.
  • Describe what a t-bill is.
  • Explain why a balance sheet must balance.
  • Explain how instability can arise in financial markets.
  • Define what is meant by an "efficient market."
  • Distinguish among floating, pegged-and-convertible, and pegged-and-nonconvertible exchange rates.
  • Explain the effects of a tariff with a floating exchange rate.
  • List some transactions that supply dollars to the foreign exchange market.
Copyright Robert Schenk