The Role of Money and Financial Markets

PART 1: INTRODUCTION TO MONEY

Money: is any item or verifiable record accepted as payment for goods and services and repayment of debts.

Functions of Money

• Medium of Exchange: intermediary instrument or system used to facilitate the purchase and sale of goods and services between parties.

• Unit of Account: Used to value goods and services, record debts, and make calculations.

• Store of Value: Retains its value, or purchasing power, and does not depreciate.

• Standard of Deferred Payment: Money is used to settle debts.

Characteristics of Money

• Durability: Long-lasting.

• Portability: Easy to carry.

• Divisibility: Can be divided into smaller units.

• Uniformity: All forms of money are identical.

• Acceptability: Widely accepted as a form of payment.

• Limited Supply: Must be in limited supply to retain value.

Evolution of Money

• Barter System: Exchange of goods and services without money.

• Commodity Money: Money with intrinsic value (e.g., gold, silver).

• Fiat Money: Money without intrinsic value but accepted by the government.

• Digital Money: Electronic form of money (e.g., cryptocurrencies).

How Money is Created

• Fractional Reserve Banking: Banks keep a fraction of deposits as reserves and lend out the rest.

• Money Multiplier Effect: The process by which banks create money through lending.

PART 2: FINANCIAL MARKETS OVERVIEW

Definition And Importance

• Financial Markets: Platforms where buyers and sellers trade financial assets.

  • Facilitate the raising of capital.

  • Promote investment and economic growth.

  • Allow risk management through diversification.

Types of Financial Markets

• Money Markets: Short-term borrowing and lending.

• Capital Markets: Long-term securities (stocks and bonds).

• Foreign Exchange Markets: Currency trading.

• Derivatives Markets: Contracts based on the value of underlying assets.

PART 3: ROLE OF FINANCIAL INSTITUTIONS

Banks

• Commercial Banks: Accept deposits, provide loans, and offer financial services.

• Investment Banks: Assist in raising capital, provide advisory services, and facilitate mergers and acquisitions.

• Retail banking: also known as consumer banking or personal banking, is banking that provides financial services to individual consumers rather than businesses.

Non-Bank Financial Institutions

• Insurance Companies: Provide risk management through insurance.

• Pension Funds: Manage retirement savings.

• Mutual Funds: Pool funds from investors to buy securities.

• Hedge Funds: Invest in a variety of assets to achieve high returns.

PART 4: FINANCIAL INSTRUMENTS

Financial instruments: are assets that can be traded, or they can also be seen as packages of capital that may be traded.

Types of Financial Instruments

• Equities: Stocks representing ownership in a company.

  • Provide capital to firms and potential returns to investors.

• Debt Instruments: Bonds and loans representing a promise to repay borrowed funds.

  • Allow entities to borrow funds and investors to earn interest.

• Derivatives: Contracts whose value is derived from underlying assets.

  • Used for hedging risks and speculation.

PART 5: INTEREST RATES

Types of Interest Rates

• Nominal Interest Rates: The stated interest rate without adjusting for inflation.

• Real Interest Rates: The interest rate adjusted for inflation.

• Fixed Interest Rates: Rates that remain the same for a set period.

• Variable Interest Rates: Rates that can change based on market conditions.

Determination of Interest Rates

• Supply and Demand for Money: Interest rates are influenced by the supply of and demand for money.

• Central Bank Policies: Central banks set benchmark interest rates.

• Inflation Expectations: Higher expected inflation can lead to higher interest rates.

Impact of Interest Rates on the Economy

• Consumption and Investment: Lower interest rates encourage borrowing and spending; higher rates encourage saving.

• Exchange Rates: Higher interest rates can attract foreign investment, affecting exchange rates.

• Inflation and Deflation: Central banks use interest rates to control inflation.

PART 6: IMPACT OF FINANCIAL MARKETS ON THE ECONOMY

Economic Growth

• Capital Formation: Financial markets facilitate the accumulation of capital.

• Efficient Resource Allocation: They ensure funds are allocated to the most productive uses.

Inflation and Deflation

• Asset Prices: Financial markets influence asset prices, which can affect inflation.

• Wealth Effect: Changes in asset prices can influence consumer spending and investment.

PART 7: EXCHANGE RATES

Exchange Rates: The price of one currency in terms of another. Exchange rates affect the competitiveness of exports and imports.

Factors Influencing Exchange Rate

• Supply and Demand

  • Currency Demand: If a country’s exports increase, foreign demand for its currency rises, leading to an appreciation.

  • Currency Supply: High levels of imports increase the supply of a currency in the foreign exchange market, potentially leading to depreciation.

• Interest Rates: Higher interest rates offer better returns on investments in a country’s currency, attracting foreign investors and increasing demand for that currency, leading to appreciation.

• Inflation Rates- Higher inflation erodes a currency's value, leading to depreciation. Countries with lower inflation rates see their currency appreciate as their purchasing power increases relative to other currencies.

• Economic and Political Stability- Stable countries are more attractive to investors.

PART 8: REGULATION AND STABILITY OF FINANCIAL MARKETS

Regulation: refers to the laws and rules governing the operation of financial markets.

Need for Regulation

• Protect Consumers: Ensure fairness and transparency.

• Prevent Crises: Reduce the risk of financial crises.

• Maintain Stability: Ensure the stability of the financial system.

Why is Regulation Important?

• Prevents fraud and protects consumers.

• Ensures the integrity of financial markets.

• Promotes confidence in the financial system.

• Reduces the risk of financial crises