Please explain how financial markets may affect economic performance.

January 2005

Great question. The simple response is that well-developed, smoothly operating financial markets play an important role in contributing to the health and efficiency of an economy. There is a strong positive relationship between financial market development and economic growth. For example, in Chapter 1 of their 2001 book, Financial Structure and Economic Growth, editors Demirgüç-Kunt and Levine concluded:

In particular, researchers have provided additional findings on the finance-growth nexus and have offered a much bolder appraisal of the causal relationship; firm-level, industry-level, and cross-country studies all suggest that the level of financial development exerts a large, positive impact on economic growth.

Financial markets help to efficiently direct the flow of savings and investment in the economy in ways that facilitate the accumulation of capital and the production of goods and services. The combination of well-developed financial markets and institutions, as well as a diverse array of financial products and instruments, suits the needs of borrowers and lenders and therefore the overall economy.

What are financial markets and institutions?

Financial markets (such as those that trade stocks or bonds), instruments (from bank CDs to futures and derivatives), and institutions (from banks to insurance companies to mutual funds and pension funds) provide opportunities for investors to specialize in particular markets or services, diversify risks, or both. As noted by Demirgüç-Kunt and Levine, together financial markets and financial institutions contribute to economic growth; the relative mix of the two does not appear to be an important factor in growth.

Large financial markets with lots of trading activity provide more liquidity for market participants than thinner markets with few available securities and participants and thus limited trading opportunities. The U.S. financial system is generally considered to be the most well developed in the world. Daily transactions in the financial markets—both the money (short term, a year or less) and capital (over a year) markets—are huge. Many financial assets are liquid; some may have secondary markets to facilitate the transfer of existing financial assets at a low cost. Table I provides a list of several well-known U.S. financial markets, ranked by outstanding assets or liabilities as of 2004.

The U.S. also has a well-developed financial services industry. It includes such familiar types of financial institutions as banks, pension funds, mutual funds, and insurance companies. Table II provides a list of several categories of U.S. financial institutions, ranked by outstanding assets as of 2004.

TABLE I

Selected U.S. Financial Markets, Outstanding Assets or Liabilities as of 1999 and 2004.