Money, Banking and Financial System: Key Concepts Explained

Money and Its Functions

Money has several key features: deposit value, unit of account and medium of payment. Payments are settled in legal tender.

Key Factors

• Risk (the possibility of losses)
• Liquidity (the ability to convert an asset into cash quickly)
• Profitability (the return generated by an investment)
• Duration (the time horizon of an investment)

Trust and Financial Instruments

Savings accounts and fixed-term deposits are different products. Fixed-term deposits require the holder to commit funds for a set period in exchange for a return, and they cannot be cancelled early without penalty.

Monetary base refers to the total amount of money in circulation.

The Banking System

Banks act as intermediaries: they collect deposits from savers and lend them to economic agents who need financing.

Fractional Reserve Banking

Banks keep a fractional reserve of deposits and lend out the rest. Because of this, banks can create money: an initial deposit of X generates a total deposit of X × 1/c, where c is the cash coefficient.

Item 13: The Financial System

The financial system is composed of a set of intermediaries that channel the savings of households toward financing for families, private consumption, business investment and public spending.

Financial Products

Financial products are titles that represent a claim on a future payment, and they generate an obligation for those who issue them.

Differences

• Liquidity: the ease and speed with which an asset can be converted into cash at a fair price.
• Risk: the probability that the issuer does not return the investment.
• Profitability: the ability of an asset to produce interest.

Stock and Bond Markets

Securities markets are organised by Stock Exchanges. Their objective is to facilitate the negotiation of securities in a competitive, orderly and continuous manner.

Main Types of Securities

• Fixed income: represents a loan granted at a fixed rate of 1% to a determined company or public administration. The return is fixed and agreed at the moment of issue.
• Variable income: the most popular are shares, which represent ownership of the capital of a company and grant the holder rights to participate in its management and economic results.

Stock Market Indicators

Stock indices are indicators of market performance. Stock market quotations represent the value of titles and their degree of liquidity.

Primary and Secondary Markets

• Primary market: channels savings into investment. The SEC authorises the issue and includes all relevant details.
• Secondary market: investors trade securities previously issued, so holders can sell titles acquired in the primary market.

Market Mode

The computer network of Spanish stock exchanges allows trading of securities through terminals, with real-time updates of all quoted values.

Business Financing

Own Resources

Companies can use their own resources, supplied by owners or shareholders through contributions. Shareholders have the right to participate in management and in the distribution of profits, which is variable income.

Retained earnings are profits not distributed, kept as self-financing to make new investments and encourage company growth.

External Financing

• Commercial credit: automatic financing a company obtains from its suppliers, which allows it to purchase materials or supplies and pay later.
• Bank loans: companies obtain financing from banks and financial intermediaries, repaying the principal plus interest under agreed conditions. Terms can be short (one year or less) or long.
• Bonds: when a company needs a large amount of money, it can issue fixed-income securities that are divided into smaller units and sold to savers.
• Spontaneous funds: resources a company receives without having to repay them within a set period.

Monetary Policy

Monetary policy consists of measures taken by the European Central Bank to achieve its objectives, through changes in the money supply and the cost of money.

Functions

• Decide and implement the monetary policy of the EU.
• Carry out foreign exchange operations.
• Promote the smooth functioning of payment systems.
• Supervise credit institutions to ensure the stability of the financial system.

Instruments

• Minimum reserves: mechanism to increase or reduce liquidity in the banking system, forcing credit institutions in the eurozone to maintain a determined cash coefficient.
• Open market operations: the main instrument, used to control the amount of money in circulation.
• Permanent facilities: facilities for liquidity that commercial banks can use with their national central bank, receiving or depositing funds overnight.

Effects

Expansive policy: an increase in the supply of money raises the funds available to banks, lowers interest rates or decreases the cash coefficient. As a result, the banking system has cheap and abundant funds, and loans become more accessible. Families and economic agents spend more, which increases aggregate demand, production and employment.

Restrictive policy: a reduction in the money supply has the opposite effect. Interest rises and loans become more difficult to obtain, so families consume less and businesses invest less. Aggregate demand, production and employment fall, and prices may decrease if the policy reduces excess stock.