The money market
We have described the financial system, and we know that the money market is an essential part of it and the foundation of the other financial markets. We defined the money market as the STDM. As far as debt instruments are concerned, the money market encompasses:
• Primary market: the issue of all forms of short-term instruments of borrowing, that is, the short-term debt of ultimate borrowers and certain QFIs, and short-term deposit instruments. Deposit instruments are the NNCDs and NCDs of banks and certain instruments of the central bank, the important ones of which are notes and coins (= part of money) and central bank securities (= a form of deposit, and an instrument of monetary policy).
• Secondary market: the exchange of existing marketable short-term debt instruments.
Hidden from the public's view, however, is an integral part of the money market: the interbank market (and there are three parts to it). These markets play a significant role in money creation and monetary policy. We discuss them in some detail later. In Figure 7 we present a summary of the money market.
Figure 7: money markets
Money market interest rates
We now need to address money market (or short-term) interest rates. Short-term interest rates, such as the banks' prime lending rate, deposit rates, and so on, are made (or discovered) in the money market and longer-term interest rates are made in the bond market. How are interest rates made? Interest rates are the price of money: the rate of interest paid on debt, to compensate the lender (buyer of the debt) for foregoing liquidity (= not spending now). Usually111, the longer the debt is the higher the rate is because the lender is foregoing liquidity for longer. Interest rates are made in the primary and secondary debt (and deposit) markets. The players in the market are the lenders and borrowers and the financial intermediaries. Of the latter the central bank is the most important - it is a player and the referee.
It is necessary now to present the concepts time value of money (TVM) and yield curve (YC). TVM is best elucidated with a question: if you were offered the choice of receiving LCC 100 today or LCC 100 in one year's time, which will you choose? Unless you have a major brain problem you will choose the latter. Why? Because it's worth more to you: you can invest the money and have more than LCC 100 in a year's time.
Therefore money has a present value (PV) and a future value (FV). PV is the LCC 100 now and FV is the value the LCC 100 escalated to a number in the future, the difference between the two being the rate of interest for the one-year term to maturity applied to the PV. You will now immediately understand that [ir = interest rate % pa expressed as a unit of 1 (let's assume 10% pa or 0.1); t = term to maturity in days divided by 365]:
This equation translates to:
Using the above numbers we have:
The converse is to derive the PV from a known FV:
Thus if we have a given number of LCC 110 in 365 days' time (= FV) we are able to calculate the PV at the ruling interest rate for the period (again assume 10% pa):
This PV-FV concept (i.e. time value of money) is the principle underlying the valuation of all assets that have a monetary value / cash flow/s in the future112: money market assets, shares, bonds and income-producing property. This principle is significant in comprehending monetary policy: when interest rates increase the value of assets falls, and vice versa. This has a major impact on aggregate demand and on the demand for bank loans. As we will see, central banks focus on and have control over interest rates.
Figure 8 shows the effect on PV (= the value of the asset) of different rates of interest: the higher the rate, the lower the PV.
Figure 8: from FV to PV (the principle)
Now, on to the YC. In the example above the "security" had a term to maturity (ttm) of one year and an interest rate of 10% pa. The 10% pa rate is the rate determined in the secondary market for this security. Now imagine tens or hundreds of government securities (bonds and treasury bills) all with different terms to maturity trading in the secondary market113. Each of them has a market rate that largely depends on the ttm.
Imagine taking a snapshot of the government securities (remember: government bonds and treasury bills) market at a specific time on a specific day, i.e. you write down the rates at which all the government securities are trading. You have two parameters: ttm and market rate (called yield to maturity - ytm -in the bond market) for each security. You plot this on a chart (in a spreadsheet); you will now have a series of crosses / dots on the screen as indicated in Figure 9. You then use sophisticated stats-moths to draw a best-fit curve as indicated by the solid line in Figure 9. This is the yield curve for government securities. Formally, it is a representation of the relationship between term to maturity and interest rate (ytm) for the government securities market.
We know that the money market is the STDM and the bond market is part of the LTDM. The cut-off point between the two is arbitrarily set at one year. Thus, in the YC the rates on government securities from 1 day to a year are money market rates, and after a year the rates are bond market rates. More essential knowledge: the rates on government securities are also called risk-free rates (rfr), and this is so because if you buy a government security you will definitely114 get your money back plus the fixed rate that applied to it.
Figure 9: normal yield curve
What is the relevance of this to money creation? It is that money creation takes place in the financial markets and it is closely related to interest rates. The government securities YC can be regarded as the "norm" or reference, and all other (non-government) rates revolve around the norm. More importantly, the central bank has the tools to influence the bottom end of the YC to a desired level. Thus, the central bank determines the bottom end of the YC, and all other interest rates react to any changes to the YC the central bank brings about.
Also, these rates represent the lowest rates of return that can be expected on investments. Thus, if rates are pushed higher, borrowers will borrow less (= a lower rate of growth in money creation = lower inflation). Individuals will have to pay more on debt, and companies will discover that new projects for which borrowing is required may not be as feasible as before (remember companies offer a return in the form of dividends) (= a lower rate of growth in money creation). Long-term investors such as retirement funds will tend to buy more bonds and fewer shares.
Conclusion: interest rates play a vital role in money creation. But before this section ends there is a need to elucidate the composition of interest rates (see Figure 10). It will be noted that inflation is a component. What influences inflation? Money growth does.
Figure 10: composition of nominal interest rates
Our starting point is the one-day rate on government securities, called the nominal (it means actual) rfr for one day. This is a rate that is available in the real world. The current inflation rate (cn) is known (at worst it is a few weeks old, but if inflation is steady it does not matter if the next one published is a few points out from the previous one); therefore you can determine the real rfr for one day (nominal rfr - cn = real rfr).
From this point on the nominal rates on all longer-term government securities are composed of the one-day real rfr, cn [or expected inflation (en) as you go longer], and the liquidity-sacrifice premium (lsp). The investor demands an lsp because s/he is sacrificing the ability to use the money now.115 The lsp increases as the ttm increases because investors demand more return for the longer sacrifice of liquidity.
You will recall that we said that the government security yield curve is the norm for rates. This statement will now become clear. Companies which borrow through the issue of bonds set the rates on their bonds with reference to the rates on government securities, that is, government securities rates are the benchmark rates for corporate bond rates. As indicated in Figure 10, they show a positive relationship with ttm.
In summary the rfr for each ttm is composed as follows:
Corporate bond rates (cbr) are composes as follows (crp = credit risk premium):
Now we know how interest rates are composed. As a quick aside: instinctively you will derive from this analysis that it is rational to benchmark any potential investment on the risk-free rates. In other words when any investment is assessed its return must be higher than the rfr as follows:
Required rate of return (rrr) = nominal rfr + a premium ror credit risk.
Figure 11: money market rates & bank margin
Back to the money market and specifically to short-term interest rates (see Figure 11). We know where the reference one-day nominal rfr is. One day debt / deposit rates are known as "call" rates; for example if you place a large amount of money with a bank and you have the right to withdraw it when it suits you, it is a call money deposit. The call rate can vary daily, depending on money market conditions (explained later in detail). Call rates are critical rates in the money market because this is where all interest rates have their genesis, and, critically, this is where the central bank intervenes to "set" short-term interest rates. As we will see, in some countries this "setting" of rates is virtually exact, and in others less so.
We now need to focus on the bottom end (money market part) of the YC and, even more tightly, to the one-day rates. Note that "one-day rates" refers not only to one-day deposits / loans but to deposits / loans where the rate is changeable daily (in theory, and this includes overdrafts). As explicated earlier, banks endeavour to earn a healthy margin. A large proportion of banks' deposits are for one day, i.e. on call. In the case of the household sector consider cheque deposit accounts, savings accounts, transmission accounts and small call deposit accounts. The rate paid on these deposits is represented in Figure 11 by the dot denoted "call deposit rate - small depositors". For the large deposits at call, which is a major component of banks' deposits, a higher call rate is paid - the dot denoted "call deposit rate - large depositors". The latter plays a mammoth role in the money market - which will become clearer later - in that they are savvy as far as what bank call rates should be, and demand the highest rates. If a bank slips on its quote the call deposit money will move to another bank. So, the market for large call deposits is efficient indeed.
All other deposit rates are related to the banks' call rates for large deposits. As we move further into the longer-term the rates are usually higher, but they are still related to the call rates.
Now consider the bank margin we spoke about earlier. As profit-maximising entities banks endeavour to maximise the margin, by paying the least for deposits and earning the most on loans extended. Their benchmark rate for credit extended is called the prime lending rate, which we will call prime rate. This is called a benchmark rate because it is a high profile rate, i.e. published at all times. It is the rate for low risk customers; all other bank credit rates are benchmarked on prime rate. Thus, you may be paying prime + 1% pa for your overdraft facility utilized while your wealthy pal may be paying prime. A large company may pay prime minus 1.5% pa, while a smaller one may be paying prime and so on and so forth. In figure 11 the bank margin is approximately denoted.
Two other one-day rates are indicated in Figure 11 that we have not spoken of before: the interbank rate and the central bank's lending rate to banks, the KIR. Both these are interbank rates, and we now turn to these and related issues.