Topic 2: The Financial System and the Real Economy

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Topic 2 The Financial System and the Real
Economy

• Lending borrowing and national income
• Financial activities and aggregate demand
• Financial system and resource allocation

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National Income Identity
where Y National income (total
income/expenditure) C Private consumption
(households sector) I Investment Expenditure
(firms) G Public sector Expenditure
(government) (X-M) External sector X
Expenditure on the economys exports by customers
overseas M Spending on imports Income and
expenditure activities of the different sectors
result in the creation of Savings Investment
Financial Surplus/deficits and Financial Net
Worth
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Lending Borrowing and National Income

• Activities of economic agents result into
  creation of financial assets (negative/deficit or
  positive/surplus).
• Financial balances of economic agents have both
  direct and indirect effects on the level
  aggregate economic.
• Financial assets enhance efficient use of real
  assets in the economy.
• Both the financial and real economic activities
  of economic agents must be balanced to bring
  about equilibrium in the National Income
  identity.

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Financial Activities and Aggregate Demand

• The total activities of economic agents make up
  the aggregate demand and aggregate supply.
• Aggregate demand is the sum of expenditures of
  all economic agents on goods and services.
• Aggregate supply is sum of total production of
  good and services within the economy through
  expansion of monetary assets and liquid assets.
• Expansion of monetary assets affects the economy
  from the framework of quantity theory of money

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• Liquidity assets are created through accumulation
  of money substitutes.
• Aggregate supply is also expanded through
  financial wealth and spending activities of
  economic agents.
• Changes in the composition of aggregate demand
  also play an important role in the expansion or
  contraction of aggregate supply.

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Financial system and resource allocation

• Financial system through the FIs helps to
  allocate financial resources within the economy.
• Even though the financial markets may not achieve
  allocation efficiency they help in allocating
  resources for productive activities.