Financial System

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1. Question 1: “The role of the financial system in a market economy is to effectively and efficiently move funds from surplus budget units to deficit budget units.” However, in the absence of well-functioning financial intermediaries this transfer of funds may be severely retarded.” Discuss. Within a financial system, surplus and deficit units trade, which facilitates the movement of funds from deficit units to have access to those with the budgeted units. Hence, there is always the incentive to trade. The role of the financial system is also to allow the deferral of expenditure. The question is often asked, how can this exchange of funds take place, one may think of it as a do it yourself project, like selling your house, without a…show more content…
– commercial bank in essence transforms a longer-term asset into a shorter-term asset - For example, a commercial bank would take depositors funds and lend the funds to another person or firm for a longer period of time, as with a loan or a mortgage. - - Without the use of an intermediary an average person would have to tie up all his or her funds for 20 years and then receive a payment every month. There would be a maturity mismatch and the only way this can be solved is through indirect financing. 2) Transaction Costs - reducing the costs of contracting and information processing. Many transaction costs are associated in the process of finance whether direct or indirect. These transaction costs can include legal and administrative fees and are broken down into four (4) major categories: – Cost of the acquisition and analysis of the information about the financial asset and its issuer also known as Search costs: both lender and borrower will incur costs of searching for, and finding information about, a suitable counterparty. – Cost of writing the loan contract - Cost of enforcing the contract terms broadly known as enforcement costs: the lender will need to ensure enforcement of the terms of the contract, or recovery of the debt in the event of default. - Verification costs: lenders must verify the accuracy of the
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