Long before formal financial institutions and instruments became common, there were times when people lacked the resources to meet their immediate needs. In the terminology of introductory economics, people's incomes were exceeded by their necessary consumption. When a harvest was poor, they would dip into the reserves stored from previous years or exchange assets like land and livestock for food. But often those measures were insufficient, so communities developed informal financial arrangements that allowed people to borrow or lend among themselves. After a poor harvest, those people with relatively good yields would help those with relatively poor ones. When the tables were turned, help would flow the other way. In some societies, families spread out geographically to facilitate these arrangements. For example, in rural Indian communities, households deliberately married off their daughters to families in different regions to increase the chance that their in-laws would be able to respond in a time of crisis.¹ These informal insurance arrangements ensured that everyone had enough to eat.

While family members and friends still make loans among themselves, the informal arrangements that were the mainstay of the financial system centuries ago have given way to the formal financial instruments of the modern world. Today, the international financial system exists to facilitate the design, sale, and exchange of a broad set of contracts with a very specific set of characteristics. We obtain the financial resources we need from this system in two ways: directly from lenders and indirectly through institutions.

In indirect finance, an institution like a bank stands between the lender and the borrower, borrowing from the lender and then providing the funds to the borrower. Most of us do our borrowing and lending indirectly. If we need a loan to buy a car, we get it from a bank or finance company—that's indirect finance. Once we get the loan, the car becomes one of our assets, and the loan becomes our liability. We all have assets and liabilities. Your assets probably include things of value like a bank account and a computer. If you have a student loan or credit card debt, those are your liabilities.

In direct finance, borrowers sell securities directly to lenders in the financial markets. Governments and corporations finance their activities in this way. These securities become assets for the lenders who buy them and liabilities to the government or corporation that initially sells them. In the next section, we'll look at these financial instruments in more detail so that we can understand exactly how they work.

Financial development is inextricably linked to economic growth. A country's financial system has to grow as its level of economic activity rises, or the country will stagnate. Figure 3.1 (23.0K) plots a commonly used measure of financial activity—the ratio of a broad monetary aggregate to gross domestic product—against real GDP per capita. The resulting correlation should not come as a surprise. There aren't any rich countries that have very low levels of financial development. In fact, the ultimate role of the financial system is to facilitate production, employment, and consumption. In a prosperous economy, people have the means to pay for things, and resources flow to their most efficient uses. Savings are funneled through the system so that they can finance investment and allow the economy to grow. The decisions made by the people who do the saving direct the investment.

In this chapter, we will survey the financial system in three steps. First, we'll study financial instruments, or securities, as they are often called. Stocks, bonds, and loans of all types are financial instruments, as are more exotic agreements like options and insurance. Exactly what are these financial instruments, and what is their role in our economy? Second, we'll look at financial markets, such as the New York Stock Exchange and the Nasdaq (National Association of Securities Dealers Automatic Quotations), where investors can buy and sell stocks, bonds, and various other instruments. And finally, we'll look at financial institutions—what they are and what they do.

¹See M. R. Rosenzweig, "Risk, Implicit Contracts, and the Family in Rural Areas of Low-Income Countries," Economic Journal 98 (December 1988).

FIGURE 3.1 SOURCE: Data are from 1999 for 81 countries from the Global Development Network Growth Database, World Bank, http://www.worldbank.org/research/growth.