Essay: Role of financial markets in a modern economy

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  • Subject area(s): Economics essays
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  • Published on: October 23, 2019
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  • Role of financial markets in a modern economy
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Question 1: Discuss the role of financial markets in a modern economy. Explain how financial markets bridge the gap between borrowers and lenders.

Financial markets play a vital role in the allocation of resources and operation of modern economies. Financial markets create products that provide a return for those who have excess funds (Investors/lenders), making these funds available to those who need additional money (borrowers). They provide a market that bridges the gap between borrowers and lenders. The ‘price’ established in this market is the rate of interest.

Financial markets are also the factor markets for capital in the economy. Capital is required by businesses as an input into the production process, so that the goods and services required to satisfy the economy’s wants can be produced. Financial Markets provide an efficient process by which income that is not used for consumption can still contribute to aggregate demand. Savings from customers, businesses and governments can not only be used for future consumption, but also to invest in capital, which increases the productive capacity of the economy.

Traditionally, consumers saved money through financial institutions such as banks. This has been the subject of change in recent years. Now Australia has the world’s highest level of share ownership. Since superannuation became compulsory it also contributed to the nation’s growing interest in more sophisticated financial instruments. This growing trend has led to financial markets developing a more important and crucial role in the economy.

Primary financial markets are markets in which firms raise funds by selling financial assets such as shares or debentures to investors. The sale of a new set of St George shares to the public is an example of a primary market transaction. Secondary financial markets are markets in which investors trade financial assets such as shares or debentures with other investors. Businesses do not receive any money from secondary market transactions.

The main financial markets that operate in an economy are the share market, the debt market, the derivatives market and the foreign exchange market.

Financial markets bridge the gap between borrowers and lenders by offering borrowers of money loans which are taken from the money in which savers deposited. Businesses borrow money in order to expand, invest in research and development or capital. Individuals also borrow but for personal purposes this might be home loan, holiday, car or an educational course. Financial institutions offer loans with the intension of making a profit by charging interest rates. Governments borrow in order to raise the economic activity and fund major infrastructure projects. Just as there are borrowers of funds there are people who have excess funds and do not want to immediately consume it. Individuals who place deposits in financial institutions are in fact lending their money to the institution for the purpose of getting a return on it. Businesses sometimes become the lenders of funds when they’re experiencing strong cash flow and profits and do not have any immediate needs for expansion. Governments also become lenders when they file for a budget surplus in order achieve the desired economic outcomes. This is when financial institutions and other organisations come in with the desire to obtain profits through charging a rate of interest. This operation of activities ensures that borrowers and lenders are satisfied by bridging the gap between.


Financial markets such as the share market, the derivatives market, the debt market and the foreign exchange market all play an important role in the allocation of resources and key operations in the economy. Financial markets offer a return for lenders and charge a rate of interest for those who borrow funds with the intention to pay it back.

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