Naked Economics: Undressing the Dismal Science

This chapter explains how financial markets work and what their purpose is. Wheelan starts by comparing them to fad diets. While it may be tempting to engage in schemes that promise rapid weight loss or a quick financial windfall, both almost always fail. The best approach to each is playing the long game with a slow and steady approach. While the array of financial instruments may seem daunting, Wheelan states that they all do the same four things.

First, they raise capital for companies, governments, and individuals, all of whom need money today to help them in the future.

Next, they protect excess capital and use it so that it makes a profit. Lending or investing it at a certain rate of interest helps protect it against inflation; this can be thought of as renting it out (economists call the interest rate a “rental rate”). Financial markets allow borrowers of capital to spend money they have not yet earned, as when a college student takes out a loan for tuition with the expectation that a future job will allow them to repay it.

Third, financial instruments insure against risk. For example, futures markets allow firms to lock in a future price of a certain commodity to protect against price swings that could affect business.