Financial system and money market

Learning outcomes

After studying this text the learner should / should be able to:

1. Describe the financial system.

2. Elucidate the market in which money is created: the money market.

3. Discuss the significance of the interbank markets in money creation.


You now know what money is: bank notes, coins and bank deposits. We now need to refine this definition. Bank notes are the notes of the central bank, and we know that because they are issued by the central bank they are part of its liabilities. Coins in many countries are also issued by the central bank; where this is not the case they are issued by a government department (usually Treasury or the Department of Finance). We will assume they are issued by the central bank for the sake of simplicity. We will call them bank notes and coins or just N&C, with the background knowledge that N&C are liabilities of the central bank. N&C are held by the domestic non-bank private sector (NBPS) and by the banks in their vaults, teller drawers and ATMs. Only the former (N&C held by the NBPS) is regarded as being part of the money stock.

Bank deposit (BD) money is a wide term. The foreign sector, government and banks also bank with banks (the latter is called the interbank deposit or loan market). Generally the deposit part of the money stock is taken to include only the deposits the NBPS. Thus we have:

Money exists and is created in the money market. The money market is a financial market and it is one of the financial markets. The financial markets make up the financial system. Therefore, if you are to understand money and money creation clearly, you need to see it as part of the financial system. Next we present a brief elucidation of the financial system, its instruments, its markets, and so on. This is followed by a definition of the money market, an exposition on money market interest rates (because they are the operational variable of monetary policy) and the interbank market/s.

The financial system


simplified financial system

Figure 1: simplified financial system

The financial system may be depicted simply as in Figure 1. It is essentially concerned with borrowing and lending and has six parts or elements (not all of which are visible in Figure 1):

• First: lenders (surplus economic units) and borrowers (deficit economic units), i.e. the non-financial-intermediary economic units that undertake lending and borrowing. They may also be called the ultimate lenders and borrowers (to differentiate them from the financial intermediaries who do both). Lenders try and earn the maximum on their surplus money and borrowers try and pay the minimum for money borrowed.

• Second: financial intermediaries, which intermediate the lending and borrowing process; they interpose themselves between the ultimate lenders and borrowers and endeavour to maximise profits from the differential between what they pay for liabilities (borrowings) and earn on assets (overwhelmingly loans). In the case of the banks this is called the bank margin. Obviously, they endeavour to pay the least on deposits and earn the most on loans. (This is why you must be on your guard when they make you an offer for your money or when they want to lend to you.)

• Third: financial instruments, which are created to satisfy the financial requirements of the various participants. These instruments may be marketable (e.g. treasury bills) or non-marketable (e.g. a utilized bank overdraft facility).

Fourth: the creation of money when demanded. As you know banks (collectively) have the unique ability to create their own deposits (= money) because we the public generally accept their deposits as a means of payment.

• Fifth: financial markets, i.e. the institutional arrangements and conventions that exist for the issue and trading (dealing) of the financial instruments.

• Sixth: price discovery, i.e. the price of shares and the price of debt (the rate of interest) are "discovered", i.e. made and determined, in the financial markets. Prices have an allocation of funds function.

We need to present you with a little more information on these six elements.

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