The Financial Sector:
The Money Market:
What is the Money Market: where financial assets are bought and sold with maturities of
less than a year - short term loan finance (e.g. government bonds with less than 1 yr
maturity, interbank lending, borrowing needs by commercial banks from central bank)
Demand for money: Downwards sloping to reflect the
inverse relationship between interest rates and the
quantity demanded for money. At a lower interest rate,
it makes more sense to hold cash as interest rates on
less liquid financial assets are low, there is less of an
incentive to invest. When interest rates are high, it
makes less sense to holds cash as money can be
invested in less liquid assets which have a higher rate
of return
Supply of money: perfectly inelastic as it is fixed by the central bank
Equilibrium interest rate: where supply of money intersects demand for money
Changes in interest rate are caused by:
● Changes in Demand for money
○ Transactions demand for money: individuals need liquid assets in order to
undertake transactions.
○ Precautionary demand for money: the desire to hold money in order to pay for
emergency expenses. If people store all their wealth in stocks and less liquid
assets they must first sell the assets in order to undertake transactions. Some
wealth will always be held in money for unexpected expenses.
○ Speculative money: the desire to hold money to be able to purchase financial
assets at the appropriate time or to hedge certain current financial risks.
● Changes in Supply of money (determined by central bank):
, ○ Reserve Requirement: the amount of money that commercial banks must
keep in the bank of england by law. Doesn’t yet exist in the UK economy but
does in the US. To reduce interest rates, they could reduce the reserve
requirement as this means that commercial banks do not have to keep as
much money in reserve and instead can keep it in the real economy
increasing the money supply. If the reserve requirement increases then
money is sucked out of the real economy and money supply falls.
○ Bank Rate: the rate at which commercial banks borrow from the bank of
England to meet their liquidity needs. This is the dominant way the BofE
alters interest rates. Borrowing from BofE is a big source of short term finance
for commercial banks. Reducing bank rate means that borrowing from BofE is
cheaper so commercial banks can charge lower interest rates on loans they
give out and vice versa.
○ Open market operations: buying and selling bonds in order to change money
supply. To increase money supply and thus decrease interest rates, the
central bank may buy bonds as this provides banks with liquidity which
increases money supply. Selling bonds means that money is taken out from
commercial banks which reduces the supply of money and increases interest
rates.
The Role of the Financial Sector:
The characteristics of money: acceptable, portable, durable, divisible, limited in supply,
difficult to forge.
Role of the financial sector:
● Facilitating saving
● Facilitating investment by mobilising savings
● Facilitating the exchange of goods and services.
● Forwards markets: enable transactions to be conducted on the basis of contracts for
future delivery. For example, net importing firms can agree to buy certain
commodities that are volatile in price at a certain price at a certain pre-decided date
in the future.
● The market for equities: investors can buy a stake in businesses that they think have
growth potential, allowing these businesses to obtain funds for investment.
The role of the financial sector in promoting economic development:
Why are savings important for economic growth?
● They provide a flow of funds into the financial system which can be harnessed to
provide new credit for business investment, new enterprises and households.
● Enables smooth household spending when incomes and employment fluctuates
● An economy where savings are low implies that the economy is choosing short term
consumption over long-term investment
● The country can get trapped in a low-level equilibrium situation: A shortage of capital
means low per capita incomes which means low savings which means low
investment which fuels the capital shortage
● Economic growth requires a shift in AS which requires investment to increase
productive capacity and savings are needed to finance this investment.
The Money Market:
What is the Money Market: where financial assets are bought and sold with maturities of
less than a year - short term loan finance (e.g. government bonds with less than 1 yr
maturity, interbank lending, borrowing needs by commercial banks from central bank)
Demand for money: Downwards sloping to reflect the
inverse relationship between interest rates and the
quantity demanded for money. At a lower interest rate,
it makes more sense to hold cash as interest rates on
less liquid financial assets are low, there is less of an
incentive to invest. When interest rates are high, it
makes less sense to holds cash as money can be
invested in less liquid assets which have a higher rate
of return
Supply of money: perfectly inelastic as it is fixed by the central bank
Equilibrium interest rate: where supply of money intersects demand for money
Changes in interest rate are caused by:
● Changes in Demand for money
○ Transactions demand for money: individuals need liquid assets in order to
undertake transactions.
○ Precautionary demand for money: the desire to hold money in order to pay for
emergency expenses. If people store all their wealth in stocks and less liquid
assets they must first sell the assets in order to undertake transactions. Some
wealth will always be held in money for unexpected expenses.
○ Speculative money: the desire to hold money to be able to purchase financial
assets at the appropriate time or to hedge certain current financial risks.
● Changes in Supply of money (determined by central bank):
, ○ Reserve Requirement: the amount of money that commercial banks must
keep in the bank of england by law. Doesn’t yet exist in the UK economy but
does in the US. To reduce interest rates, they could reduce the reserve
requirement as this means that commercial banks do not have to keep as
much money in reserve and instead can keep it in the real economy
increasing the money supply. If the reserve requirement increases then
money is sucked out of the real economy and money supply falls.
○ Bank Rate: the rate at which commercial banks borrow from the bank of
England to meet their liquidity needs. This is the dominant way the BofE
alters interest rates. Borrowing from BofE is a big source of short term finance
for commercial banks. Reducing bank rate means that borrowing from BofE is
cheaper so commercial banks can charge lower interest rates on loans they
give out and vice versa.
○ Open market operations: buying and selling bonds in order to change money
supply. To increase money supply and thus decrease interest rates, the
central bank may buy bonds as this provides banks with liquidity which
increases money supply. Selling bonds means that money is taken out from
commercial banks which reduces the supply of money and increases interest
rates.
The Role of the Financial Sector:
The characteristics of money: acceptable, portable, durable, divisible, limited in supply,
difficult to forge.
Role of the financial sector:
● Facilitating saving
● Facilitating investment by mobilising savings
● Facilitating the exchange of goods and services.
● Forwards markets: enable transactions to be conducted on the basis of contracts for
future delivery. For example, net importing firms can agree to buy certain
commodities that are volatile in price at a certain price at a certain pre-decided date
in the future.
● The market for equities: investors can buy a stake in businesses that they think have
growth potential, allowing these businesses to obtain funds for investment.
The role of the financial sector in promoting economic development:
Why are savings important for economic growth?
● They provide a flow of funds into the financial system which can be harnessed to
provide new credit for business investment, new enterprises and households.
● Enables smooth household spending when incomes and employment fluctuates
● An economy where savings are low implies that the economy is choosing short term
consumption over long-term investment
● The country can get trapped in a low-level equilibrium situation: A shortage of capital
means low per capita incomes which means low savings which means low
investment which fuels the capital shortage
● Economic growth requires a shift in AS which requires investment to increase
productive capacity and savings are needed to finance this investment.
