© 1990 KJuwer Academic Publishers The Financial System and Economic Performance

The core function of the financial system is to facilitate the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment. This system includes the basic payment system through which virtually all transactions clear and the capital markets which include the money, fixed-income, equity, futures, and options markets and financial intermediaries. The capital markets are the medium that makes possible the basic cash-flow cycle of household savings flowing to capital invest ments by firms, followed by a return to households (via profits and interest payments) for consumption and recycling as new savings. Through often-elaborate financial securities and intermediaries, the capital markets provide risk-pooling and risk-sharing opportuni ties for both households and business firms. Well-developed capital markets allow for separation of the responsibility for the capital-flow requirements of investments from the risk-bearing responsibility for those investments. In both an international and domestic context, this facility permits efficient specialization in production activities, according to the principle of comparative advantage. In addition to these manifest functions, the capital market serves an important, perhaps more latent, function as a key source o