Chapter 12: Problem 3

What is a financial intermediary? Give an example of how your bank or credit union serves as a financial intermediary between you and the rest of the economy.

Short Answer

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Answer: A bank or credit union serves as a financial intermediary between an individual and the rest of the economy by taking in deposits from savers and lending out this money to borrowers. This process facilitates the movement of money within the economy and promotes growth and stability. For example, when an individual deposits money into a savings account, the bank may lend this money to a business owner in need of funds for expansion. The bank profits from the difference between interest rates for savers and borrowers, while effectively channeling funds from savers to borrowers to benefit both parties and the overall economy.

Step by step solution

Define financial intermediary

A financial intermediary is an institution or individual that serves as a middleman between two parties in a financial transaction. They facilitate the flow of funds between those who have surplus funds (savers) and those who need funds (borrowers). This process is essential for the efficient allocation of resources within an economy and helps maintain economic stability.

Identify the role of a bank or credit union

A bank or credit union is a type of financial intermediary that takes in deposits from individuals and businesses (savers), and lends out this money to other individuals and businesses (borrowers) in need of funds. In this way, they facilitate the movement of money within the economy. Banks and credit unions profit from the differences between the interest rates they offer to savers and the interest rates they charge borrowers.

Example of a bank or credit union as a financial intermediary

Let's consider an example to illustrate how a bank serves as a financial intermediary. Suppose you deposit $1,000 into your savings account at your local bank. This money is considered a surplus fund, as you do not currently need it for your expenses. The bank then lends out this money to a local business owner who needs funds to expand their operations. In this example, the bank is acting as the financial intermediary between you (the saver) and the business owner (the borrower). You lend your money to the bank by depositing it into your savings account, and the bank lends this money out to the borrower. The bank earns a profit by charging a higher interest rate on the loan to the business owner than it offers you on your savings account. Through this process, your funds are effectively channeled from you to the business owner, benefiting both parties and the overall economy by promoting growth and stability. Ultimately, this example demonstrates how a bank or credit union serves as a financial intermediary between individuals and the rest of the economy by transferring surplus funds from savers to borrowers in a convenient and efficient manner.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Economic Stability

Financial intermediaries like banks and credit unions play a pivotal role in facilitating economic stability. By channeling funds from savers to borrowers, they ensure a steady flow of money, which is essential for economic growth and the prevention of market imbalances. Economic stability is marked by steady growth, low inflation, and low unemployment rates.

These institutions achieve stability through the diversification of investments and the expert management of risk, which in turn reduces the likelihood of financial crises. By providing loans for various purposes such as consumption, investment, or business expansion, they support different economic sectors, thereby fostering a resilient and balanced economy.

Resource Allocation

Resource allocation is significantly influenced by financial intermediaries, as they direct funds to where they are needed most. Their role in assessing the creditworthiness of borrowers signifies that capital is more likely to be lent to businesses and individuals that will use it productively.

This efficient resource allocation leads to the optimal use of funds in an economy, promoting growth and innovation. Without intermediaries, savers might struggle to find promising investment opportunities, and potential borrowers might not have access to necessary capital, leading to an economic slowdown.

Savings and Borrowing

The relationship between savings and borrowing is intrinsic to the role of financial intermediaries. These institutions offer secure options for individuals to save money, like savings accounts and certificates of deposit, while simultaneously offering loans for various needs such as education, home ownership, or starting a business.

By doing so, they bridge the gap between those with surplus capital and those with capital deficits. This also impacts personal financial management, as people can more easily plan for the future, knowing they have both options readily available.

Interest Rate Disparity

Interest rate disparity refers to the difference between the interest rates on deposits (savings) and the interest rates on loans (borrowings). Financial intermediaries profit from this disparity, which compensates them for their services and the risks they take on.

The rates are influenced by several factors including, the Central Bank's policies, market demand, risk assessment, and competition among financial institutions. While this disparity is necessary for intermediaries to function, extreme variations can have repercussions on the economy, affecting everything from consumer behavior to business investments.