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Importance Of Money Banking And Financial Markets Economics Essay

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Published: Mon, 5 Dec 2016

Bond Market is a mechanism where buyers and sellers of Financial Securities trade a financial claim of property on the money given to another person for a specified period of time at a particular rate of interest. Bonds are the economic indicators for determining interest rate over the loan obtained by private corporations and govt.

Interest Rate is the cost of borrowing or the price paid for rental of funds or the price for not using his own money. Interest rates vary with the period of loan. For long term loan, it is lower. For medium term loan, it is almost average but for short term loan, it is usually higher than average. Interest rates derive the economy by increasing or decreasing the money supply in the financial markets.

Demand for Money Interest Rate Supply for Money

When the central bank wants to control inflation by reducing money supply in the economy, it increases interest rate which results in low demand for money. But this factor causes low investment, consequently people become unemployed and national output falls.

On the other hand, when central bank wants to boost up economic and business activities in the country, it allow commercial banks to advances loans at low rate of interest, consequently supply of money in the economy increases. At this stage people have much more investment opportunities but they have no or low savings. With falling interest rate and more supply of money consumers rush towards the consumption of money on different products and services which causes general price level to raise hence inflation increases with the decrease in interest rates.

Stock Market:

Stock Market is a market place where Stocks (Common Stock, a share of ownership in the corporation’s earning and assets as a security for the money provided by individual investor to the company) of different companies are traded. Prices are quoted in the market demand and supply of shares of a particular company. Higher share price indicates that the affairs of corporate are being conducted in accordance with the rules, policies and commitment which the directors assure to each individual shareholder.

Foreign Exchange Market:

FEM is that market place where currencies from one country (say PKR) to another country (say US$) are traded. Foreign Exchange has strong impact on the economic position of any country. When 1US$ = 52 PKR, Pakistan have less exports to other countries because Pakistani products are expensive for foreign importers as compared to when 1US$ = 86 PKR as they get less Pak- rupees against one US dollar. On the other hand, when 1 US$ = 52 PKR, Pakistan have more imports from other countries because Pakistani importers have to pay less Pak-rupees to get dollars as compared to when 1 US$ = 86 PKR.

2) Why Study Banking and Financial Institutions?

Structure of Financial Systems:

Finance means the management of Money and funds. Companies need such funds for long term investments and for running their day to day operations. Individual households save and indirectly lend their savings to such corporations. Banks, Insurance Companies, Mutual Funds, Investment Banks, Saving Banks and finance banks are financial intermediaries, who takes deposits of households and lend it to the corporations and consumers. Against the savings of households, it gives interest at lower rates to households but charge high rate from companies or consumers for the loan given to them. The difference between these two rates is the profit of financial intermediaries.

Banks and other Financial Institutions:

Banks are financial institutions that accept deposits and make loans. Banks include Central bank, Commercial banks, Investment banks, finance banks, Saving banks, loan associations, credit associations, mutual funds, pension funds, insurance companies and other such like institutions who act as an intermediaries between those who lend and who borrow. Against the loan or lending, banks take collaterals and fill other legal documents as a guarantee to get their money back. Normally banks provide consumer loans as well as industrial but consumer funds bear more rate of interest than industrial because they are non-productive in nature.

Financial Innovation:

Innovation means improvement in the old systems or processes. Today banks are innovating with different financial instruments and options which start with the Information Technology to E-Finance. In old ages, people withdraw money by filling a cheque but today by ATM. Account balance can be checked at home PC. Consumer finance including Car, house, marriage and other facilities are part of this innovation. Foreign Trade through L/C or TT and local trade by DD and TCs are also innovative ideas. Now banks offer insurance facility, running finance, partnership, educational loans, lockers facility and other financial service are a way to attract customers and making their profits higher and higher.

3) Why study Money and Monetary Policy?

Money is anything which is generally accepted in payment for goods or services or repayment of debts. Changes in economic variables are the result of change in money supply in the economy and hence monetary policy holds vital importance for the economy.

Money and Business Cycle:

Business Cycle is the continuous change in the position of business from Boom to decline to depression to recovery and then to boom. In the period of boom, economy has much more money supply and higher production and aggregate output. Labor force is employed and there is less rate of unemployment. With the higher rate of interest, money supply fall and now national output and production comes down which results in the higher rate of unemployment in the period of declining economy. When economy is at its depression stage, unemployment rate is very high with highest rate of interest which results in low money supply and bottom level of national production. Finally when economy is at the stage of recovery, money supply increases with the increase in production and output, which results in the low unemployment rate. This cycle repeat it again and again.

Money and Inflation

Inflation is the continuous rise in the prices of goods and services in the economy. The average price of goods and services in the economy is called aggregate price level or price level. Such increase in the price level affects the individuals, businesses and govt. Most probable cause of this inflation is the increase in the money supply in the economy which increases buying power and consumption trend of people. When many people rush to buy a particular goods or services, its price rises and hence it results in increase in inflation in the economy. Price level and Money supply generally move close to each other. Formula for calculating inflation is the rate of change in the price level relative to a base year’s price, what we study in index number calculation. Countries having higher inflation rate must have higher level of money supply and vice versa. Milton Friedman says, “Inflation is always and everywhere a monetary phenomenon.”

Money and Interest Rate:

Interest rate on the bonds and bank loans fluctuates with the change in money supply in the economy. With more supply of money in the economy, there will be low interest rate and with less money supply, economy bears high interest rates. So, interest rate and money supply are two important factors of monetary policy of any economy.

Conduct of Monetary Policy:

Central bank of the economy like SBP regulates the money supply and rate of interest to formulate a reasonable and growth oriented monetary policy so that all economic variables show their favorable movement for economy growth and prosperity.

Fiscal Policy and Monetary Policy:

Monetary policy is the supply of money in the economy to control inflation, national output and other economic variables while Fiscal policy is the decision of govt. regarding its revenues (taxes) and expenditures (development expenditures). Budget deficit is the increase in govt. expenditures over its revenues. Budget surplus is the increase in govt. revenue over its expenditures. In the period of budget deficit, govt. takes developmental loans from Central bank, financial intermediaries, IMF, World Bank, Assian Development Bank and other financial institutions to meet their financial needs. Budget deficit also results in the increase in money supply and hence interest rate increases. Surplus or deficit is normally measured as a percentage of GDP or aggregate output of the economy.


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