Role of financial institutions
Financial institutions play a significant role in the economy. Most importantly, they facilitate the flow of funds between households and companies. The absence of these institutions would imply that corporations will directly approach households for funds. However, this may not be practical in a real-life situation. Therefore, financial institutions play a significant intermediary role between savers (households) and users (companies). This role benefits both households and firms by reducing the cost of information. Apart from the brokerage function, the institutions also play the role of asset transformation. In this case, they sell their securities, which are designed to attract households and use the earnings to buy securities for corporations. Therefore, the absence of these institutions may create some economic hindrances that will curtail the flow of funds between households and firms.
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The first hindrance is the inability of the household to monitor the activities of firms. Monitoring function gives the savers some assurance that their funds are properly invested. This role is vital, though costly, time-consuming, and requires skilled workers. Thus, households would prefer this activity to be carried out by others (Siddiqui, 377). Lack of monitoring will increase the risk of the flow of funds from households to corporate. Another hindrance that may arise due to the absence of financial institutions is the cost of liquidity. Generally, corporate debt and equity are long-term in nature. Households will shy away from the long-term investment in these assets irrespective of the returns due to the risks involved. Savers would prefer short-term investment in a scenario where there are no financial intermediaries. This is likely to cause liquidity problems in the financial market. Finally, the absence of financial intermediaries is likely to result in a high cost of transaction due to information asymmetry. This is due to the fact that users do not have adequate information about the lenders (Satija 402).
Characteristics of money
Money facilitates the smooth running of the economy due to the following characteristics. First, money can easily be divided into small parts, which allow people to carry out transactions. Secondly, it is portable. Thirdly, money is widely accepted as a means of trade. Also, money must be limited and not easy for people to get it. Further, it should be able to endure wear and tear. Finally, it should be stable. This implies that its value should stay fairly constant over a long period (Keynes 209).
Functions of money
Money has four functions in the economy. First, it is used as a means of trade. This implies that it is used for the final payment of goods and services. Secondly, money keeps value until it is exchanged for goods and services. Thirdly, it is used as a unit of account. This enables the evaluation of the values of various goods and services. Finally, it is used as a standard of deferred payment. In this case, it is used to state the value of debt (Rotheim 106).
Importance of money
Money is the lubricant of an economy because it facilitates the smooth running of all economic activities in public finance, consumption, and distribution, among other areas. In consumption, money act as a means of trade since it enables consumers to allocate income in a manner that maximizes the level of satisfaction (Khanna 314). In industries, money enables manufacturers to compensate for all factors of production. In terms of trade, it eliminated barter trade and made the process easy. Further, money facilitates the process of budgeting. Thus, national income and expenditure can be measured in monetary terms. Also, it aids in transforming savings into investments. Finally, it helps in allocating resources into different lines of production (Mankiw 261).
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Rothe, Roy. New Keynesian Economics/ Post Keynesian Economics. Routledge, 2013.
Satija, Kalpana. Textbook on Economics for Law Students. Universal Law Publishing Co. Pvt. Ltd., 2009.
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