Alright. So now let's learn some details about the financial system and let's start off with a few key definitions. So we're gonna be talking about in the next few videos, the financial system? And this is the idea that there's gonna be households that are saving some of their money. So in general, householders save some of their money while firms need money to invest in long term assets. So the money that that households are saving is being invested by firms, they're gonna borrow that money and invest it. Okay, so the financial system, it's the group of markets that where these firms are acquiring the funds from Savers. So the households are saving money and the firms are borrowing that money to invest. Right? So financial markets this when we talk about the group of financial markets, well, there's tons of different financial markets and I'm sure you've heard some of them markets for purchase and sale of financial securities, such as stocks and bonds. Right? So when we think about a firm selling stock to the public or selling bonds to the public, well, this happens in financial markets. Right? So this is exactly what happens, the firms are going to be selling securities. So this is how financial markets work. The firm sells a security to the household. So the household now has this financial investment, right? The security is a financial investment for the household and then the household gives cash, right cash to the firm and the firm needs that to make investments in say long term assets, like a new factory machinery, things like that. Right? So the financial market facilitates that. It gives the firm's ability to sell things to the household these securities to the household to raise cash, right? So that they can have cash. So when we talk about investment in this class, just like we just said, the household makes an investment in these securities. Well, that's a financial investment. Okay, So when we talk about investment, specifically in economics, financial investments, we were talking about economic investments. And that deals with this definition here, current resources are devoted to increasing future output. Right? We've talked about this before. So when we talk about the term investment, well, there's two types of investments, right? Financial investments and economic investments are focused mostly in this course is economic investments. But they do like to talk about financial investments as well. So, these are generally made by households financial investments. I'm gonna put that in quotations here, households. Because yes, firms can also buy stock and bonds of other of other firms. Right? But in general, the idea here is that the households are making these investments, stocks and bonds are the most common uh financial investments that there are compared to economic investments that are made by firms. So, firms are the ones who buy factories, machinery, right? These long term assets. I'll put L. T. Assets that they use to grow their business to increase future production, right? Just like we have in our definition current resources devoted to increasing future production. So they're taking some of their resources now, and they're devoting it by building a factory. Well, they're not gonna increase production now, they're building a factory that will increase production in the future. Okay. So that's generally what we're talking about when we talk about investment in this class and in the future videos coming up. Okay, So just like we have up here this financial market that we showed up here. Well, sometimes it's not directly that the firms are directly selling a security to the households. Sometimes there's what's called financial intermediaries that we have right here. Financial intermediaries. And these are firms that act as a middleman. So instead of let's say Apple selling stock directly to uh you well, there could be an intermediary, some sort of investment bank or some sort of mutual fund in the middle. That uh makes the process a little easier of raising the money and selling the securities. So I'm gonna draw a little diagram down here uh where we have a little space here, so we might have something like this. I'll do it down here. So we'll have firms and then in the middle we'll have the intermediary. And then over here households, I'm gonna put H. H. For households. Right? So the firm here uh sells securities, I'll put securities instead of cell. So security goes from the intermediary to the firm. Excuse me. The firm sells, let's say their stock, the firm of Apple stock gets bought by the intermediary, let's say a mutual fund and the intermediary gives them the cash. So there we go. The firm is able to get the cash right away. Right? But now what the intermediary does is it sells let's say stocks in the mutual fund. So the mutual fund. So now instead of buying shares in Apple stock, you might buy shares in this mutual fund of a bunch of different stocks together and now you bought instead of a share of Apple, you bought a share of mutual fund and that mutual fund constitutes a lot of different types of shares. We'll talk a little about a little bit more about mutual funds in the future. But this is the idea of a financial intermediary. So now notice the intermediary is able to make the movement of the cash more rapid because they're able to buy the securities and give the cash immediately to the firm rather than finding household buyers. While the intermediary is gonna take care of that. The intermediary can now advertise their mutual fund and sell the mutual fund and raise that cash back here. Right? So they'll make some money on fees or whatever they charge um to make money for facilitating this. Cool. So that's what the financial intermediary does. They're basically this middleman in between the firm and the household that facilitates the movement of the cash. Alright, let's take a quick pause here and we'll talk about these three goals that the financial system accomplishes.
Role of the Financial System
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Alright. So let's talk about these main goals of the financial system. Why do we have a financial system, What does it accomplish? So the first one here is reducing transaction costs. The transaction cost is basically the cost of negotiating a deal. Okay, so think about a firm that's trying to raise $1 billion right there, trying to raise $1 billion. It's probably gonna be very difficult to find one person who's like, here's a billion dollars. Go do what you will, right? That's a lot of risk for one person to take on. However the business could, instead of finding an individual investor, they can sell $1000 bonds. Right? And maybe now investors are more likely to invest by just investing $1000. Well, they can find a lot of people who are willing to invest $1000 rather than one person that's willing to invest a billion dollars, Right? So a bond market makes it easier for a firm to raise large amounts of money because they can find lots of individual investors will to put in smaller amounts, Right? So there's a lower transaction cost rather than trying to find one person, they're probably gonna have to go through a lot of trouble finding one person or if there wasn't even a bond market where you can easily put your bond out there to find investors. Well, that would also make it difficult. You'd have to call everyone and be like, hey, do you want to buy $1000 bond? Hey, no, there's a bond market where this information is easily accessible. So it reduces those transaction costs. Next. It reduces financial risk. So when we talk about risk in this class, risk has to do with uncertainty. When we talk about financial risk. Well, it's uncertainty about the future gains or losses. So anytime we think about risk, that's about, we're uncertain about the future. What is gonna happen? We're not totally sure, right? So that adds risk because we're not totally sure. So financial risk is uncertainty about making money or losing money. What's gonna happen? Right? So we can reduce our financial risk by diversifying. I'm sure you've heard this word before, diversifying your investments if you have a bunch of different investments, well, there's less, less of a chance that they're all gonna do something, they're all gonna lose money, right? Some will gain money, some will lose money and you diversify some of that risk away. Right. Another thing you can do is buy insurance, right? That's another way you can reduce your risk is by ensuring against those losses. Cool. So the financial system allows those types of things to happen, you're able to buy a bunch of different investments, you're able to buy insurance thanks to the financial system. And finally, it provides liquidity when you do have an investment, you want to be able to sell that investment whenever you're ready to sell it, right? Just because you have a share of stock. Well, you don't wanna be stuck with it, right? At some point, you might need the cash, you want to be able to sell it. So liquidity is the idea of being able to convert a financial asset to cash, right? So you're gonna have some sort of asset, like in our example, you own 10 shares of Apple stock, but you need cash. The financial system makes it easy to sell that stock, right? There's a readily available price for that stock if you want to sell it. Well, you put it on the market, you don't even need to know the person buying it from you. You just put it on the market and some I was gonna buy it, right? So instead of having, you know, call everybody, you know, hey, do you want to buy my shares of Apple stock? No, there's a there's a readily available financial market and you're able to sell that stock so it provides liquidity. It makes it so you can make these investments and you can disinvest as easily as you can invest, right? So those are the three main goals here, reducing transaction costs, reducing risk and providing liquidity. Cool, Let's take a pause and we'll move on to the next video