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Financial Sector

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Financial Sector

You probably don’t know it, but you have been involved in the financial sector from an early age. You have been participating in it since the first time you bought something in a shop in exchange for cash. The financial services sector or the financial sector provides financing solutions for individuals, firms, and governments, which in turn contributes to economic stability and growth. Let’s find out what the financial sector really is and what specific function it serves.

Financial sector definition

What is the definition of the financial services sector?

The financial services sector is the part of an economy that provides financial services for individuals and businesses. The financial sector is made up of firms and institutions that provide financial services to customers. These include banks, insurance companies, brokers, and real estate firms.

Most economies around the world are monetary economies in which goods and services are traded via the intermediary of money. Thus, to understand the importance of the financial services sector, we need to examine the nature of money and money supply in an economy.

Money supply in the financial sector

What is the money supply in the financial sector?

The money supply is the total amount of money in an economy at a point in time.

Before monetarism, money supply wasn’t given much attention because, in the Keynesian view, money has no effect on macroeconomics. This all changed at the advent of monetarism. In the 1970s, money began to gain more weight in the economy, causing economists to focus more on determining which assets to include or exclude from the money supply.

In the UK, there are two ways to measure money supply:

  • Narrow money consists of cash, liquid bank, and building society deposits, reflecting money’s function as a means of payment.
  • Broad money is made up of cash, liquid assets such as bank and building society deposits, as well as some less liquid assets.

Note here that broad money includes both liquid and illiquid assets, as opposed to narrow money which only consists of liquid assets.

Liquidity measures the ease to convert a financial asset into cash without loss of value.

The less liquid an asset is, the less likely it will be used as a medium of exchange. Cash is the most liquid asset of all as it can be immediately used as a means of payment.

Assets and liabilities in the financial sector

Assets and liabilities are two important concepts associated with services in the financial sector.

Assets are the things you own that offer a future economic benefit whereas liabilities are things you owe to others.

Banknotes and coins traded in an economy can be viewed as both an asset and a liability.

Suppose you get a loan from a commercial bank. The loan is your liability but the commercial bank’s asset. However, since the bank has to ‘deposit’ money from another account to your bank account, it creates liability for itself simultaneously.* Here, the loan is both an asset and a liability to the bank.

In the above example, the loan-creating process increases the bank’s assets and liabilities by the same amount. The creation of credit (an asset from the bank’s point of view) happens at the same time and in equal amounts as the deposit of credit (a liability from the bank’s point of view).

* The bank doesn't actually take money from another customer’s account but creates new money to lend you.

To learn more about the money creation process, check out our explanation on the Money Market.

Portfolio balance decisions in the financial sector

Portfolio balance decisions are choices people make over which assets to own. These include physical assets such as houses, land, or art and financial assets such as cash, government bonds, shares, or bank deposits. Financial assets are ranked according to the level of liquidity and profitability.

Financial Sector Diagram showing the portfolio balance decisions StudySmarterFig. 1 - Portfolio balance decisions

As you can see in Figure 1, liquidity is the ease with which an asset is converted into cash. Cash is the most liquid asset and thus treated as money. Government bonds and shares (not money) are the least liquid financial assets but can earn the owner interest over time.

Impact of financial sector development on economic growth

What is the impact of financial sector development on economic growth? The financial sector is made up of firms and institutions that provide financial services to customers. The financial sector makes money by lending savings of idle cash to those in need. Thus, it gains more profits as the interest rates drop as people are more likely to borrow money at a lower interest rate.

Businesses use these loans to purchase equipment and expand their business growth, which contributes to economic development. This is why a strong financial sector indicates a healthy economy.

The financial sector also helps to stabilize the economy by satisfying both the supply and demand sides of money. Through the financial institutions, those with idle cash can lend out their money to collect interest while companies and governments can get loans quickly to fund their financial projects.

The UK financial sector examples

Some examples of the UK financial sector include:

  • money markets
  • capital markets
  • foreign exchange markets

The UK financial sector or financial market is a market that facilitates the trading of financial assets or securities.

Figure 2 illustrates the components of the UK financial market.

Financial Sector Diagram showing the financial market components StudySmarterFig. 2 - Financial market components

UK financial markets are divided into capital markets that supply medium to long-term or undated financial assets and money markets which provide short-dated financial assets. There are also foreign exchange markets, consisting of spot markets and forward markets.

To learn more about the different types of financial markets, read our explanation on Financial Markets.

Businesses in the UK financial sector: impact of Brexit

Let's now take a closer look at the impact of Brexit for businesses in the UK financial sector. Brexit is the withdrawal of the UK from the European Union after 47 years of membership. The UK voted to leave the EU in 2016 but only officially left on 31 January 2020.

Brexit has brought significant changes to the relationship between the UK and the EU:1

  • Previously, goods in the UK and other European countries could be traded without taxes or restricted amounts. While this remains the same, there are new rules and standards on workers’ rights, social, and environmental regulations.
  • The UK will no longer benefit from passporting which allows it to export goods and services to EU countries without any complex procedure.
  • UK citizens are also no longer free to work in the EU and vice versa. They need to acquire a visa to stay more than 90 days in a 180-day period.
  • The UK can set its own trade policy since it is no longer a member of the EU.

Trends in UK financial sector: impact of Brexit

Let's take a look at some of the trends in the financial sector in the UK. According to the New Financial2, so far Brexit has impacted the UK’s financial services sector in three main ways:

  • More than 440 banking and financing institutions have relocated from the UK to the EU.
  • 10% of UK bank assets (the equivalent of £ 900 billion) have been or will be moved to the EU.
  • 7400 financial services jobs have also been moved to the EU.

There will be disruptions to trade, investment, immigration, and jobs in the UK, but there are also major benefits as the country is no longer held under EU regulations and rules. It can choose its own path and increase its competitiveness in the global market.3

Financial Sector - Key takeaways

  • Financial markets support the trading of financial instruments in an economy.
  • Money is a major component of the financial market.
  • Trading in the financial market is associated with assets and liabilities. Assets are the things you own that contribute to future income whereas liabilities are what you owe to others.
  • The financial sector can drive economic growth and is important for balancing the supply and demand of money in the market.
  • The financial market is divided into the capital market, money market, and foreign exchange market

References

  1. BBC News, Brexit: What you need to know about the UK leaving the EU, 2020, https://www.bbc.co.uk/news/uk-politics-32810887
  2. Eivind Friis Hamre and William Wright, Brexit & The City: The Impact So Far, New Financial, 2021, https://newfinancial.org/brexit-the-city-the-impact-so-far/
  3. The Week, The pros and cons of leaving the EU customs union, 2019, https://www.theweek.co.uk/brexit/93104/brexit-pros-and-cons-of-leaving-the-customs-union

Frequently Asked Questions about Financial Sector

The financial services sector is the part of an economy that supports the trading of financial instruments such as stocks, bonds, foreign currency, insurance and commodities. It also regulates the balance of supply and demand of money by lending money from private savings to those in need.

Companies in the financial sector include: banks, insurance companies, credit rating agencies, etc.

The role of the financial sector is to provide financial services for individuals and businesses.

The 4 main types of financial institutions are:

  • Banks
  • Insurance companies
  • Investment banks
  • Tax authorities

The financial sector impacts the economy because businesses use these loans to purchase equipment and expand their business growth, which contributes to economic development. This is why a strong financial sector indicates a healthy economy.

Final Financial Sector Quiz

Question

Define supply-side policies.

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Supply-side policies are policies that aim to increase productivity and efficiency in the economy.

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What is the objective of supply-side policies?

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The objective of supply-side policies is to boost aggregate supply (AS) to result in increased output.

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How do supply-side policies impact the LRAS curve?


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They aim to shift the LRAS curve to the right.

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How do supply-side policies aim to reduce inflationary pressure?

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By removing market imperfections.

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What are the two types of supply-side policies?


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Free market and interventionist policies.

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What do free market supply-side policies aim to encourage?


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Competition, market reform, and incentives.

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What is privatisation?


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When the government sells its previously state-owned assets to private individuals or companies.

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Deregulation can:


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All the answers are correct.

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Name an example of trade liberalisation.

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Eliminating trade barriers like tariffs.

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How could decreasing corporate taxes impact aggregate supply?


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Decreasing corporate taxes can allow firms to retain more of their profit and invest it back into the economy, increasing the output of the economy and shifting LRAS to the right.

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What are interventionist supply-side policies?


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Interventionist supply-side policies are policies that require government intervention to boost the economy.

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Name two examples of interventionist policies.


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Investment in human capital and investment in new technology.

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Which of the following is NOT an interventionist policy?


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Reducing unemployment benefits.

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Name two advantages of supply-side policies.

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Sustainable growth and the ability to increase employment.

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Name two limitations of supply-side policies.


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Time lag and costs.

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What is aggregate supply?

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Aggregate supply (AS) is a measure of the total volume of goods and services produced in the economy over a given time period.

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Name two types of aggregate supply.

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Short-run and Long-run

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What remains constant in the movement along the aggregate supply curve?

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Other factors

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What changes in the shift of the aggregate supply curve?

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Other factors

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Which is the vertical aggregate supply curve?

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The long-run aggregate supply curve

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What is the Phillips curve relationship?

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The Phillips curve relationship is an inverse statistical relationship between the rate of inflation and the rate of unemployment.

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How is the Phillips curve drawn?

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The Phillips curve is drawn as a downward sloping smooth curve in the unemployment-inflation plane.

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How are the rate of inflation and the rate of unemployment related according to the Phillips curve relationship?


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The rate of inflation and the rate of unemployment are inversely related. As the rate of unemployment decreases, the rate of inflation increases and vice versa.

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How many inflation theories does the Phillips curve relationship explain?


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Two inflation theories.

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Which inflation theories does the Phillips curve relationship explain?


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The Phillips curve relationship explains demand-pull inflation and cost-push inflation theories.

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What is the cause of demand-push inflation?


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Excess demand in the economy.

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What is the cause of cost-pull inflation?


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Rising costs of production due to trade unions bargaining for higher wages on behalf of the employees.

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What is the long-run Phillips curve?


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The long-run Phillips curve is a vertical line crossing the short-run Phillips curve at a point where the short-run Phillips curve crosses the horizontal axis.

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At which point does the long-run Phillips curve cross the short-run Phillips curve?


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A point where the inflation rate is zero and unemployment rate is called the natural rate of unemployment.

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What is the natural rate of unemployment?

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The natural rate of unemployment is the long-run level of unemployment below which employment can’t increase without accelerating the rate of inflation.

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Why is the long-run Phillips curve vertical?


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The long-run Phillips curve is vertical at the natural rate of unemployment because the trade-off relationship between the rate of unemployment and the rate of inflation disappears in the long-run.

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What does the Phillips curve predict?


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The Phillips curve predicts a trade-off between the rate of unemployment and the rate of inflation.

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Why is the Phillips curve important?


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The Phillips curve is an important tool for the government policy of reducing the rate of unemployment in the economy whilst taking into account the rate of inflation.

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What are adaptive expectations?


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Adaptive expectations are a type of agents’ expectation formation about the future solely based on the values observed in the current and recent past periods.

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What are rational expectations?


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Rational expectations  are a type of agents’ expectation formation about the future based on all the observed data (current and past), whilst acting in their full self-interest.

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Can unemployment be reduced in the long run?


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Unemployment can be reduced in the long run if the government implements appropriate supply-side policies to reduce the natural rate of unemployment.

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What will be a result of a supply-side policy targeted at reducing the natural rate of unemployment in the long-run?


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Shift in the LRPC

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What will be a result of a demand-side policy targeted at reducing the natural rate of unemployment in the short-run?

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Movement along the SRPC

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What does the trade-off region on the Phillips curve represent?

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The trade-off region on the Phillips curve represents the government's options. There are several policy choices that a government can pursue when targetting a particular level of employment and inflation.

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Which expectation theory underpins the short-run Phillips curve?


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Theory of adaptive expectations

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Who suggested the other concept of LRAS?

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Keynesians.

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When does macroeconomic equilibrium occur?

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Macroeconomic equilibrium occurs when aggregate demand meets aggregate supply.

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How can we determine the output gap?

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The output gap is the difference between the actual output and the potential or trend output.

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What are the types of the output gap?

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  1. Positive output gap
  2. Negative output gap

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What is a positive output gap?

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A positive output gap occurs when the actual output is above the potential or trend output.

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What is a negative output gap?


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A negative output gap occurs when the actual output is below the potential or trend output.

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What is Gross Domestic Product?

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Gross domestic product (GDP) is the total economic activity (total output or total income) in a country's economy.

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There are ____ ways of measuring GDP.

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3

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What are the three ways of measuring GDP?

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Expenditure, income and output.

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Explain the output approach of measuring GDP.

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This approach includes adding up the total value of final goods and services produced in a country's economy over a period of time.


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