Describe two ways in which financial intermediaries help lower transaction costs in the economy.

Name: Problem 2, Chapter 7: Financial Markets and Institutions
Uploaded: 2021-04-08T17:54:47-08:00
Duration: 11 min 12 s
Channel: Aryan Tiwari
Description: Describe two ways in which financial intermediaries help lower transaction costs in the economy.

step 1 So let's understand what financial intermediaries are. Let's say we have a group of people that

Describe two ways in which financial intermediaries help...

Key Concepts

Financial Intermediaries

Financial intermediaries are institutions that connect savers with borrowers, thereby channeling funds from those with surplus savings to those in need of funds. They streamline the process of matching individuals or entities by assuming the complexity of evaluating and monitoring credit risk, ultimately reducing the redundancy and uncertainty that can come with direct transactions.

Transaction Costs

Transaction costs represent the expenses associated with conducting an economic exchange. These include costs for information gathering, negotiation, monitoring, and enforcement of agreements. Lowering these costs is crucial for a more efficient economy, and intermediaries play a significant role in minimizing these expenses by centralizing and simplifying transaction processes.

Economies of Scale and Specialization

By handling a large number of transactions, financial intermediaries benefit from economies of scale, where the cost per transaction decreases with an increasing volume. Their specialized expertise in managing funds and assessing risk enables them to efficiently process transactions compared to individual investors or direct negotiations between borrowers and lenders.

Mitigation of Information Asymmetry

Information asymmetry occurs when one party in a transaction has more or better information than the other, often leading to inefficient outcomes. Financial intermediaries reduce this imbalance by conducting thorough screenings and ongoing monitoring of borrowers, which minimizes the risk of adverse selection and moral hazard, thereby lowering the overall costs associated with gathering and verifying information.

Transcript

00:01 So let's understand what financial intermediaries are.

00:03 Let's say we have a group of people that are called savers.

00:09 Savers who have income higher than the amount they want to consume right now.

00:15 Then we have other group called borrowers.

00:21 Borrowers who want to spend more than they have access to right now whether in order to consume, say a house or a car or in order to invest that money in some business project.

00:34 Now, borrowers include.

00:39 All the servers include students, students or let's say house home buyers.

00:59 Then we have businesses or the business projects.

01:10 Now, how do we link savers and buyers together? well, we could have a direct market where savers lend directly to students, home buyers and businesses.

01:19 Problem is that it would be hard for students to track down all the different people he'd need to lend him that money.

01:25 And we could just rely on rich people to do all the savings and all that stuff.

01:31 Now, to establish a direct connection between savers and borrowers, we have financial intermediaries to solve the purpose.

01:44 Financial intermediaries.

01:56 Now, savers directly deposits with these financial intermediaries.

02:09 Deposits with these financial intermediaries and these financial intermediaries.

02:13 Intermediaries lends or say invest with the borrowers, lends or invest in the projects with the borrowers.

02:27 Now borrowers in return pays certain amount of interest to these financial intermediaries, pays interest interest to these financial intermediaries and these financial intermediaries they keep some of that so that they can profit but they send some of that interest back to savers.

02:53 They send some of that interest back to savers.

03:00 Now there are a few examples of financial intermediaries that come in between savers and buyers.

03:05 Let's understand them.

03:07 So the examples of financial intermediaries.

03:13 First being the commercial banks, commercial banks, then we have credit unions, mutual funds, mutual funds, pension funds and lic.

03:41 So these are some of the financial intermediaries that help establish relationship between savers and buyers.

03:47 Now let's understand transaction cost.

03:53 So transaction cost is the time and money spent in carrying out financial transaction.

04:11 It is the time and money spent in carrying out financial transaction.

04:22 Like we have savers and investors.

04:24 There are some savers and investor who do not have the right expertise and time to engage in exchange transactions...

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