Finance - II

Money and the Monetary System

30 Dec 2024

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Savings-investment process

The savings-investment process refers to the direct or indirect transfer of funds from savers to borrowers. Savers are individuals or institutions that have excess funds that they want to invest. We also call them surplus economic units, because their income is greater than their expenditure. We can identify three ways in which funds can be transferred from savers to borrowers:

• Direct tranfers through the purchase of debt or equity securities issued by the borrower. For example, a company can issue stocks or bonds to raise capital from investors. Savers are inclined to invest in these securities because they offer the potential for returns in the form of dividends or interest payments.
• Indirect transfers through financial institutions that act as intermediaries between savers and borrowers. Here, we can distinguish between two types of indirect transfers. One typically involves investment firms, which purchase securities on behalf of their clients. The other involves other institutions which also purchase securities, but instead of reselling them to clients, they issue their own securities to investors.

The monetary system

The monetary system is responsible for creating and regulating the supply of money in the economy. One key institution in the monetary system is the central bank, which is responsible for defining and implementing monetary policy. They are also responsible for providing financial services such as check clearing and electronic fund transfers.

A monetary system also has a network of depository institutions to support its operations. These depository institutions are financial institutions that play the crucial role of creating money in an economy through fractional reserve banking. In short, depository institutions accept deposits from savers, and then lend out a portion of these deposits to borrowers. Money is created when the borrowers deposit the loan proceeds back into some other depository institution. The amount that is lent out depends on the reserve requirement, which is set by the central bank. A lower reserve requirement means that more money can be created through the lending process, which can help stimulate economic growth.

Money

Real assets include the direct ownership of physical assets such as land, buildings, machinery, and equipment. Financial assets, on the other hand, represent claims on the income generated by real assets. For example, a homeowner has a real asset in the form of a house, which can generate income through rent. If the homeowner wants to borrow money, they can use the house as collateral to secure a loan. Banks feel confident lending money to the homeowner because they know that (1) the homeowner has a real asset that can generate income to repay the loan, and, if this fails, (2) they can take possession of the house and sell it to recover the loan amount.

Money is a form of financial asset that is widely accepted as a medium of exchange in an economy. We use it to buy and sell goods and services, and to settle debts. Money replaced the earlier barter system to solve the problem of the double coincidence of wants. Moreover, money is held as a store of value, which is to say that we can save it for future use, without worrying about any losses in purchasing power. A high and stable purchasing power is desirable because it incentivizes people to save money (if the purchasing power of my money decreases over time, I would rather spend it now than save it for later), which can then be used to finance investments and economic growth through the savings-investment process. Purchasing power is reduced by inflation. Any asset that can be exchanged for money without significant loss of value is called a liquid asset. Money is also used as a unit of account, which is to say that we use it to measure the value of goods and services in an economy.

Money market securities

Money market securities are financial assets that mature in less than a year. In general, they have low default risk (thus low returns) and high liquidity. Some examples of money market securities are:

• Treasury bills issued by the government to finance its short-term obligations. They are considered risk-free because they are backed by the full faith and credit of the government. They are also highly liquid because they can be easily bought and sold in the secondary market. T-bills come in varying maturities, and higher maturities generally offer higher returns.
• Commercial papers and repurchase agreements are short-term loans issued by business firms. Commercial papers are unsecured promissory notes (i.e. they are not backed by collateral, but by the creditworthiness of the issuer), whereas repurchase agreements involve the sale of securities (most commonly T-bills) to raise funds, with an agreement to repurchase them at a later date (typically at a higher price).
• Negotiable certificates of deposit are time deposits issued by banks that can be traded in the secondary market. The depositor/lender receives a higher interest rate than a regular savings account, but they must pay a penalty if they withdraw the funds before the maturity date. Negotiable CDs differ from non-negotiable CDs in that no secondary market exists for the latter.
• Banker's acceptances are short-term credit instruments issued by a company that has been guaranteed by a bank. A firm issues a banker's acceptance to raise funds for a specific transaction, and promises to repay whoever holds the acceptance at a later date. The bank guarantees the payment, which makes the acceptance more attractive to investors.
• Federal funds are short-term loans made between banks. For example, a bank with excess funds may lend them to another bank with a shortage of funds. The interest rate on these loans is called the federal funds rate.

Money supply measures

The M1 money supply only measures the types of money used as a medium of exchange in an economy. These include: currency in circulation, demand deposits held at banks, and other checkable deposits. The majority of the M1 money supply is made up of currency and demand deposits.

The M2 money supply is a broader measure that emphasizes the store of value in addition to the medium of exchange functions of money. M2 includes M1 plus all highly liquid financial assets, including savings accounts, small time deposits, and retail money market mutual funds (MMMFs). MMMFs are mutual funds that invest in short-term debt securities, and are considered to be highly liquid because they can be easily converted into cash.

Money supply and economic activity

Economists agree that there is a correlation between the money supply and economic activity. But the exact nature of this relationship is still debated. Monetarists believe that changes in the money supply directly affect the level of economic activity. Increases in the money supply lead to higher spending, which in turn leads to either inflation or economic growth. On the other hand, Keynesians believe that the relationship between money supply and economic activity is more complex. Increases in money supply cause interest rates to fall (more money is supplied than is being demanded), which in turn leads to increased consumption and/or investment spending, i.e. economic growth.