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Role of Financial Systems in a Modern Economy

According to Ray Dalio the economy is like a machine. A machine is made up of several different components that when all working together run smoothly, the several different components that keep an economy running smoothly is known as the financial system. The financial system is made up of the central bank, markets, and financial institutions, and when all working in harmony in turn creates a smooth economy.

The central bank prints money and controls interest rates, the financial institutions are a place where savers take their money to earn more and borrowers go to borrow money to purchase a home or invest in a business, and the markets are in place so that businesses can get investors to grow their business and investors can earn more on their investments. When all the parts of a financial system works harmoniously the citizens of a country benefit tremendously. Since a good financial system means a good economy it means that interest rates will be lower and with lower interest rates it means that borrowers will borrow more and invest more in business ventures which in turn creates more jobs. The more jobs there are for the citizens of a country the more they spend which means more money gets pushed back into the economy, and creates a booming economy. In a perfect world the financial system would always work perfectly and the economy would always boom, but unfortunately we know from past events in the United States that is not the case. The great depression and the recession in 2008 are both examples of how a faulty financial system can cause the economy to crash.

The main cause of the great depression and the recession in 2008 was said to be the government. In the case of the great depression the Federal Reserve contributed to the crisis because the economy was booming when interest rates were low and people were applying for loans, the government decided to suddenly the raise of interest rates which caused a sudden halt in the boom. Whereas, with the recession in 2008 banks were allowing uncreditworthy individuals to apply for mortgages loans that they were unable to pay back. Similarly, both presidents at the time respond to the financial crisis the same way with a federal budget and instead of cutting spending both presidents went on to spend more money. After the increase in federal spending unemployment remained high during both crisis. During Roosevelt’s presidency unemployment was at twenty one percent and during Obama’s term unemployment was eight percent and increased over two percent over time. During the great depression and the recession both presidents were spending a lot of money and it did not help unemployment rates instead unemployment still remained high. When an economy is falling, the government turns to the wealthy for more money and taxes this is what happened during the great depression. This put many Americans in the fiftieth percentile tax bracket meaning the wealthy had to pay more than half of their income. President Obama is trying to tax differently, instead of taxing the wealthy President Obama is raising taxes on items like cigarettes, liquor, plane tickets, and soft drinks. The recession is said to be the next worse period since the great depression. During both crisis the housing market was booming with low interest rates and the banks were lending money to people who were unable to pay back loans, the unemployment rate was high, and taxes were being raised. It was almost as if the past was repeating itself, the 2008 recession was going in the direction of the great depression.

In order to prevent financial crisis such as the great depression and the recession of 2008 the financial system is highly regulated. As history in the United States shows when the financial system is left largely alone, the financial system has experienced periods of instability that have led to economic recessions. (Jafri, 2015) There are now several different measures put in place in order to monitor and regulate the financial system such as the Securities and Exchange Commission, SEC, and the Federal Deposit Insurance Corporation, FDIC, the Office of the Comptroller of the Currency, and the Federal Reserve System.

The Security and Exchange Commission regulates the financial markets to help build the trust of investors in the markets again and “was created to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation”. (http://www.sec.gov) The Federal Deposit Insurance Corporation, FDIC, was created to help restore the trust of the depositors in the banks, it insures deposits made at financial institutions and the Office of the Comptroller of the Currency helps to regulate federally chartered banks. Finally, the Federal Reserve is the central bank of the United States and is also known as the “Fed”. It is ran by the Board of Governors, which consist of seven member who are appointed by the president of the United States. The Federal Reserve acts as a lender of last resort and makes short- term loans that provide banks with funds. “During the economic crisis that began in 2007, the financial system was disrupted, and large sections of the U.S. economy were cut off from the flow of funds they need to thrive.” (Hubbard, O’Brien, 2012, pg. 1) The financial crisis resulted in a decline in productions of goods and services throughout the economy.

What does the financial system do? Economist believe there are three Key elements provided by banks to a financial system; risk sharing, liquidity, and information. Risk sharing is a service the financial system provides that allows savers to spread and transfer risk. Whereas, with liquidity it allows savers and borrowers to exchange assets for money. Lastly, information is important because in it is a collection and communication of the information and expectations borrowers need to know about return on assets. All these measures are taken by the government so that the citizen of the United States have more faith in the financial system.

The key to a great economy is a great financial system. History has shown, with events like the Great Depression and the Recession in 2008, that there are hiccups that happen from time to time but federal regulation helps to restore faith back in the financial system so that citizens of the United States will continue to save, borrow, invest, and spend which are all key components to a booming economy functioning smoothly.


The Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation. (2013, June 10). Retrieved June 30, 2015, from http://www.sec.gov/about/whatwedo.shtml

Dalio, R. (2013, September 22). How The Economic Machine Works by Ray Dalio. Retrieved June 30, 2015, from https://www.youtube.com/watch?v=PHe0bXAIuk0

Richard, R. (2013, November 22). The Great Recession of 2007–09 – A detailed essay on an important event in the history of the Federal Reserve. Retrieved June 30, 2015, from http://www.federalreservehistory.org/Events/DetailView/58

Folsom, B. (2010, May 20). Comparing the Great Depression to the Great Recession. Retrieved June 30, 2015, from http://fee.org/freeman/detail/comparing-the-great-depression-to-the-great-recession

Hubbard, R., & Brien, A. (2012). Money, banking, and the financial system (Second ed.). Boston: Prentice Hall.

Dr. Jafri Chapter notes

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