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Money, Banking & Interest Rates

1. The global financial system

The global financial system is comprised of a set of market-related institutions that includes financial markets, financial institutions, laws, procedures and regulations, as well as the set of techniques through which securities of all types of financial products and/or services are bought and sold.

1.1. The global financial system as a marketplace for the demand and supply of capital.

It could be argued that the financial system is one of the most fundamental products of modern societies, insofar as it reflects an interplay between the demand to financially service the needs of global financial consumers.

In essence, the financial system’s main task is to serve as a meeting point between the lending of scarce loanable funds from investors seeking a given rate of return, and the need to move the said loans to the hands of those investors interested in borrowing these amounts in order to buy goods and services, or to make investments in new equipment, facilities, or other productive assets. These asset purchases and/or investments typically foster investment schedules in order to help grow the economy, and expand the standard of living enjoyed by a given economy’s citizens. In the absence of the global financial system, and without the ability to allocate funds from lenders to borrowers, the significant diffusion of financial products and/or services would not be available to fully service the wide range of financial consumers at a global level.

1.2. The global financial system and the occurrence of market failures: the importance of the credit channel

The financial system essentially determines both the cost/return and the quantity associated with the provision of funds between parties in the financial markets. These operations are an integral part of the millions of goods and services purchased every day through multiple markets, and whose payments indelibly pass through some payment gateway associated with a certain segment of the financial industry.

Nevertheless, it should be observed that financial markets are periodically prone to market failures, insofar as the events (however extreme) occurring within the financial industry might also have important repercussions on the overall health of the global economy. For example, the latest global financial crisis is an example of a market failure that compromised the major goals associated with the basic general mechanisms associated with the financial markets.

One obvious shock transmission mechanism is the credit channel. When liquidity becomes constrained in the aftermath of a systemic shock, funds become less available and more costly. The scarcity of loanable funds subsequently affects, for example, personal consumption expenditures, as well as investment - this constitutes the essence of the economic underperformance associated with a liquidity shock (Gambacorta and Marques-Ibanez, 2011). This impact thus depresses the overall spending for goods and services, severely impacting the performance of real economies. As a direct consequence, unemployment rises and the economic growth stalls, as businesses cut back on their production schedule and dismiss their workforce. The decentralisation of the global financial system

Furthermore, it should be observed that that are several types of financial markets within the highly decentralised structure of the global financial system. That is, within the global financial system, there are several specific markets that are bound by a particular set of financial operations that share common characteristics. These distinct types of markets may be characterised as quite structured channels through which a vast pipeline of loanable funds is continually transferred between those who supply funds to those who seek to use those funds to finance a set of economic activities to which capital financing is crucial. The ‘meeting point’ (i.e., the market equilibrium) between the demand and supply of loanable funds is thus the capital and interest rate earned by providers of available funds on the amount of capital lent, which is billed to those who seek to use the said capital for their economic activities. These specific financial market segments typically move a vast flow of loanable funds that continually replenish these specific segments. Some of the basic types of markets will be hereinafter described.

1.3. The decentralisation of the global financial system

Furthermore, it should be observed that that are several types of financial markets within the highly decentralised structure of the global financial system. That is, within the global financial system, there are several specific markets that are bound by a particular set of financial operations that share common characteristics. These distinct types of markets may be characterised as quite structured channels through which a vast pipeline of loanable funds is continually transferred between those who supply funds to those who seek to use those funds to finance a set of economic activities to which capital financing is crucial. The ‘meeting point’ (i.e., the market equilibrium) between the demand and supply of loanable funds is thus the capital and interest rate earned by providers of available funds on the amount of capital lent, which is billed to those who seek to use the said capital for their economic activities

1.4. A brief definition of money

Broadly viewed, money encompasses a set of highly ‘liquid’ financial assets comprising cash, as well as other highly liquid assets (e.g., such as the monies easily available through checking accounts) (Mishkin, 2004). In the absence of money, the transaction of goods and services might have to be made through barter exchange (whereby a good would be sold in exchange for another good), which requires extensive ‘matching’ between the needs of buyers and sellers alike (Banerjee and Maskin, 1996). Money thus becomes the common denominator between the two parties involved in any transaction for goods and services, as it constitutes a common yardstick for both of these parties, eschewing the need for both buyers and sellers to match their needs through lengthy bargaining processes.

2. The demand for money

2.1. The opportunity cost of holding money

This is due to the fact that, when a given financial agent opts to hold cash, this financial position carries a cost insofar as the said amount of money might be earning interest, but the economic agent has decided to forego that marginal income on the referred amount in order to use this position for some specific non-savings related purpose. For example, a given consumer may need to make a purchase requiring payment on demand.

2.2. Reasons for holding money

Economic agents might want to hold money due to three different reasons (Mishkin, 2004). First, taking into consideration that economic agents need to use cash in order to settle frequent purchases of goods and services. That is, the economic agent needs to hold cash for transaction purposes. Second, economic agents might want to hold money to settle for uncertain events. Third, economic agents may want to hold liquid assets in order to rebalance her/his financial portfolios. In this specific case, economic agents might hold a portfolio comprising several types of securities (such as stocks, bonds, or hybrid securities), and holding money (e.g., cash) might alter the portfolio’s financial profile.

Essentially, demand for money is established by either families (households) and/or firms, and might be viewed as the total sum associated with the three previous motives.

One of the most important determinants for holding money is thus the level of interest rate, as economic agents and firms who hold money typically pay a price which is reflected in the opportunity cost of holding money (Krugman, et al., 2011). This opportunity cost is the foregone interest rate that could be obtained should the said money be earning interest. That is, the opportunity cost for holding money is reflected in the lost interest when the money is not used as a saving instrument over time.

2.3. The demand for money curve

A simple curve depicting this relationship between money and interest rate can be drawn based on the negative association between these variables. Accordingly, the curve representing the money demand curve depicts the negative relationship between the interest rate offered by the financial markets and the quantity of money demanded by economic agents. The curve thus has a negative slope, insofar as a higher level of interest rates offered by the market is associated with a higher opportunity cost related to holding money. That is, a higher interest rate also reduces the overall quantity of money demanded by economic agents (Krugman, et al., 2009).

FIGURE 1. THE MONEY DEMAND CURVE

Interest rate (r)

r*

q*Quantity of money demanded (q)

2.4. Shifts in the money curve

Nevertheless, it should be observed that certain economic circumstances may dictate that the demand for money curve might shift over time.

Accordingly, a change in the demand for money may occur when there are changes in the aggregate price level, or in real GDP, or even within the banking industry and the corresponding technology it promotes.

FIGURE 2. THE MONEY DEMAND CURVE AND CORRESPONDING CURVE SHIFTS

Interest rate (r)

r*

D0  D1    D2

            q***      q**Quantity of money demanded (q)

When economic agents demand more money, the corresponding money demand curve shifts to the right (D1 to D2), and the quantity of money demanded rises for any given interest rate.

3. The supply of money

There are multiple technical monetary measures associated with the money supply. For example, there are several standard (i.e., universally accepted) measures of the money supply that reflect these type of assets. Amongst others, these measures include, for example, the monetary base, as well as the monetary aggregates such as M1 and M2.

Types of money

Typically, these concepts of money are quite well documented by a given economy’s central bank, and information on the existing categories is quite readily available. This is in stark contrast to the information concerning the money demand (and the corresponding curve), which has to be estimated using advanced mathematical techniques of econometric extraction. Another important contrast to the demand for money framework is associated with the fact that the money supply framework is essentially determined by financial institutions, such as the central bank or other financial institutions concerned with the process of ‘money creation’ the most important agents are the following: i) the economy’s central bank; ii) the banks; iii) depositors; and iv) borrowers from banks.

3.1. The ‘creation’ of money: the institutions

In essence, money is not only created by the central banks (e.g., the coins and notes in circulation), but is also ‘created’ through the concession of credit by financial institutions that are willing to take depositors’ monies and ‘farm’ them out to borrowers that will subsequently apply these funds for productive- or personal consumption-related investments and assets. The borrowers can then pay the initial capital plus the accrued interested to the financial institutions involved as the money lenders, and these proceeds can then cover the financial institutions’ obligations towards their financing sources (e.g., deposit holders).

3.2. The creation of money: the process and the credit multiplier

In order to initiate the process of money creation, central banks typically deal with each financial institution (banks) under their supervision, they typically conduct open market operations by buying/selling securities (e.g., bonds) to banks. When central banks buy bonds, they inject liquidity (i.e., money) in the banks and into the financial system in the form of deposits. Banks thus receive or support financing through this special relationship with their corresponding central bank. In turn, when the monies lent are, for example, applied in a given investment project, these funds not only stimulate economic growth (as investment is a fundamental determinant of GDP), but these monies are then deposited at another financial institution by these funds’ recipients. The money creation process thus continues at this second bank (and the funds, minus the required reserves, are lent for another entirely different purpose). This is the essence of an expansion of the money supply, as the process continues indefinitely, although the multiplier effect decreases with each round.

3.3. The money supply curve

Overall, it should be observed that the money supply process is not very sensitive to the overall level of interest rates.

FIGURE 3. THE MONEY SUPPLY CURVE

Interest rate (r)

q****Quantity of money supplied (q)

The money supply is typically the same regardless of the level of interest rates prevailing in the economy. The quantity of the money supply is thus established at q****.

4. The market equilibrium between the demand and supply of money

FIGURE 4. THE DEMAND AND SUPPLY FOR MONEY: THE MARKET EQUILIBRIUM

Interest rate (r)      MS

r*

(market clearing rate)

    MD

q*Quantity of money in equilibrium (q)

4.1. The equilibrium between demand and supply

The equilibrium point is thus attained through the intersection of the demand and supply curves at (r*,q*). It should be observed that this is a unique point. Should the market interest rate be above r*, the money demand curve would suggest a demand for money lower that q*. In this case, the supply of money would still be q* (higher than the demanded quantity). Given that there would be excess liquidity in the system (as the money demanded would be lower than the supplied), the interest rate would fall until r* was reached, matching demand and supply. The market would then clear at (r*,q*).


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