The Financial System: Opportunities and Dangers

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When written in Chinese the word crisis is composed of two characters. One represents danger, and the other represents opportunity.

—John F. Kennedy

In 2008 and 2009, the U.S. economy experienced a historic crisis. As we discussed in previous chapters, a decline in housing prices led to problems in many financial institutions, which in turn led to the most severe economic downturn since the Great Depression of the 1930s. This event was a vivid reminder of the inextricable links between the financial system and the broader economy. When Wall Street sneezes, Main Street catches a cold.

In this chapter we examine the links between the economy and the financial system more thoroughly. We discuss what the financial system is and how it works. We also discuss the new challenges that the financial system offers to policymakers charged with promoting short-run economic stability and long-run economic growth.

The financial system has been present in much of the macroeconomic theory we have developed throughout this book. In Chapter 3 we discussed a model of the loanable-funds market. There we saw that the interest rate adjusts to balance the supply of loanable funds (derived from the nation’s saving) and the demand for loanable funds (for purpose of investment). In Chapter 8 and Chapter 9 we used the Solow model to examine the sources of long-run economic growth. In that model, the financial system is in the background, ensuring that the economy’s saving is directed into investment and capital accumulation.

The financial system has been similarly present in our short-run analysis. In the IS–LM model of Chapter 11 and Chapter 12, the interest rate is the link between the goods market and the money market. In that model, the interest rate determines both the cost of holding money and the cost of borrowing to fund investment spending. It is therefore the crucial variable through which monetary policy influences the aggregate demand for goods and services.

By studying the financial system in more detail, we can make our analysis of economic growth and fluctuations more nuanced. The financial system is more than a single market for loanable funds, and there are more prices in this system than a single interest rate. Indeed, the complexity of the financial system is sufficiently great that there is an entire subfield of economics, called finance, devoted to its study. This chapter focuses on a couple of topics within finance that are crucial to a fuller understanding of macroeconomics. We start by examining the fundamental role of the financial system in the economy. We then examine the causes of financial crises and the policy responses to them.

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