Understanding the Role of Financial Markets in Economic Growth

Financial market report with pen and calculator

Financial markets provide for the efficient allocation of resources within the economy. Through organized and regulated exchanges, financial markets provide participants with some assurance that they will be treated fairly and honestly. The financial markets provide businesses and governmental entities access to capital. They also provide employment to many thousands of individuals who work in the financial industry.

Identification

A financial market is one that permits the buying and selling of a resource. An example of a commonly traded resource includes company stock, foreign currency, commodities including gemstones, oil and precious metals, or financial instruments such as swaps, options and futures. The New York Stock Exchange is a financial market for stocks and financial instruments, and the Foreign Exchange Market allows brokers to exchange currency.

Effects on Businesses

Financial markets directly affect publicly traded business. A steep decline in the DOW due to a large blue chip stock posting a loss often shaves several points off another company's stock, even if its operations are entirely unrelated. When a company's stock price dips, its ability to raise capital is diminished. Robert Heilbroner explains in his book "Economics Explained" that the stock market affects business in three ways: Expectations of the business climate mirror stock prices, business have a harder time issuing new securities to investors when the stock price is low and when the markets tank, businesses grow tempted to acquire others.

Effects on the Economy

Financial markets influence public perception and shape the economic landscape. A strong rally on Wall Street instills confidence in businesses to expand operations and take risks. In these cases, companies hire more workers, improve the employment rate and in turn, give consumers more disposable income. Market crashes signal the opposite: Companies grow concerned over how to fund their operations, layoffs rise and consumers don't spend as much disposable income.

Regulation

The United States established the Securities and Exchange Commission in 1934 to ensure companies are transparent with their financial data and certain aspects of their business operations. Oversight comes in the form of quarterly and yearly earnings reports, routine audits and the imposition of penalties for rule-breakers.

Regulation, however, is sometimes insufficient in preventing a financial market crash. Robert Kolb, author of the book "Lessons from the Financial Crisis," is one of many who purport the mortgage meltdown of 2008 was largely because of the government's lack of oversight. Kolb asserts that the government should have provided more oversight with regard to the banks' risky lending activity.