1.1 Six Parts of the Financial System

The financial system can be broken down into six main parts: money, financial instruments, financial markets, financial institutions, regulatory agencies, and central banks. We will talk about each of these parts in turn.

The first part of the financial system is money. Money can be used to pay for purchases, and as such, money stores wealth. Way back in the day, people would simply trade goods and services to each other based on what they needed, which is called a barter economy. However, a barter economy does not always work. For example, if a wheat farmer needs meat from a rancher, but the rancher eats a low-carb diet and wants no wheat, there will be no trade. So eventually, people started using items with some form of intrinsic value, such as gold or silver, to purchase goods or services from each other. This made it much easier to purchase those goods or services—the wheat farmer could buy meat from the rancher using gold, and in turn, the rancher could buy iron from a smith with that same gold. Eventually, the metals or other items with intrinsic value used to purchase things changed to paper currencies, such as the U.S. dollar we use today. Now, markets have gone as far as to use electronic funds. An example of using an electronic fund is when you go to the store and buy a pack of gum with your credit card. No physical money is exchanged. Electronic funds from your bank account are transferred directly to the bank account of the store, and the settlement of the exchange happens immediately. One of the most recently developed types of money is cryptocurrency. Cryptocurrency is disrupting monetary markets and is a topic we will go over in more detail later in this book.

The second part of the financial system consists of financial instruments. Financial instruments are used to transfer resources from savers (investors) to businesses or other investors. Examples of financial instruments are stocks, bonds, and derivatives such as options. The price of a financial instrument is determined mostly by supply and demand. For example, a stock’s price is determined and documented through market transactions between buyers and sellers—that is, the price of a stock is what the buyer agrees to pay a seller for it. Mutual funds and other investment companies use a combination of financial instruments to build investment portfolios.

Financial markets are the third part of the financial system that we will cover in this class. Financial markets allow for the buying and selling of financial instruments. For example, the New York Stock Exchange and NASDAQ are formal financial markets. Most markets now operate electronically, reducing transaction costs and improving the ability of small investors to participate.

The fourth part of the financial system consists of financial institutions. Financial institutions provide access to financial markets, collect and process information, and provide financial services. An example of a financial institution is your local bank or credit union down the street. Another example is the famous investment bank Goldman Sachs.

Regulatory agencies are the fifth part of the financial system. Regulatory agencies were introduced as a result of the Great Depression, and they ensure that elements of the financial system operate safely and reliably. Other monumental economic crashes, such as the 2007–2009 financial crisis, led to greater regulation of the financial system.

The last part of the financial system consists of central banks. The role of a central bank is to monitor and stabilize the financial system. Central banks control the availability of money and credit, attempting to manage inflation, economic growth, and financial stability within the financial ecosystem. Central banks use two main levers of monetary policy to accomplish this goal: (1) adjusting interest rates in bank-to-bank lending and (2) controlling the money supply in the economy. The central bank of the United States is known as the Federal Reserve System, or in short, the Fed.