Key Concepts of Money and Financial Markets

Functions of Money

Money serves several crucial functions in an economy:

• Means of Payment or Exchange: Money is a generally accepted means of payment for goods and services.
• Store of Value or Wealth: Money can be stored more easily than many other assets due to its small size and does not deteriorate over time, preserving its purchasing power.
• Unit of Account: The valuation of all products, services, and incomes is conducted in terms of the prevailing monetary unit, allowing for easy calculation and comparison of values.

Definition of Money

Money is any generally accepted means of payment that also serves as a store of value and a unit of account.

Types of Money

• Lawful Money: This is money issued by an institution that holds a monopoly on its manufacture, such as a central bank (e.g., banknotes and coins).
• Bank Money (or Deposit Money): This type of money is created by commercial banks through client deposits and the granting of loans.

The Financial System

The financial system comprises a set of institutions that mediate between those who demand and those who supply financial resources.

Banking Intermediaries

Mainly banks and savings banks, these institutions have the capacity to create money through lending and deposit-taking activities.

Non-Bank Intermediaries

This category includes, among others, investment firms and insurance companies. These institutions typically do not have the ability to create money themselves.

The Money Supply

The money supply refers to the total amount of money available in an economy. Deposits that people keep in banks can originate either from the delivery of cash or checks payable to the account holder, or from the granting of loans by financial intermediaries, which are then made available to applicants in their respective accounts.

Interest Rates

Interest is the price paid for the use of money. Each financial asset offers a different interest rate based on three key factors:

• Risk: The greater the perceived risk of default or loss, the higher the interest rate typically demanded by lenders.
• Term (Maturity): Generally, the longer the period for which money is borrowed or invested, the higher the interest rate due to increased uncertainty over time.
• Liquidity: This concept refers to the ease and speed with which an asset can be converted into cash without significant loss of value. Assets with lower liquidity often command higher interest rates as compensation.

Money Market and Capital Market

Financial markets are broadly categorized by the maturity of the financial assets traded:

• The Money Market: This is where wholesale financial products with short-term maturities (typically less than one year) are traded.
• The Capital Market: This market, meanwhile, trades financial assets with maturities of more than one year, including stocks and long-term bonds.

The Capital Market can be further categorized based on when the operation is performed:

Primary Market (Issuance)

This is where a financial instrument is negotiated for the first time. Banks often play an important role in advising issuers and placing newly issued securities with investors.

Secondary Market (Trading)

This market deals with the subsequent sale and purchase of previously issued securities among investors, providing liquidity to the primary market.

The Stock Market

The stock market serves as a meeting place for savers looking to invest their money and those who wish to sell previously acquired securities. Shares are among the most frequently traded assets on this market.