2.4.1 The Structure of Financial Markets and Financial Assets

The Functions and Characteristics of Money

The Functions of Money

• Medium of Exchange: Money is used to buy and sell goods and services, facilitating trade.
• Unit of Account: Money provides a common measure of value, allowing for the comparison of prices and the calculation of profits and losses.
• Store of Value: Money can be saved and used in the future, allowing individuals to defer consumption.
• Standard of Deferred Payment: Money can be used to settle debts and obligations over time, allowing for the creation of credit and lending.

The Characteristics of Money

• Durability: Money should be able to withstand wear and tear, so that it can be used over time without losing its value.
• Portability: Money should be easy to carry and transport, so that it can be used in a variety of locations and situations.
• Divisibility: Money should be easily divisible into smaller units, so that it can be used for transactions of varying sizes.
• Uniformity: Money should be uniform in appearance and value, so that it can be easily recognised and accepted by all parties in a transaction.
• Acceptability: Money should be widely accepted as a medium of exchange, so that it can be used in a variety of transactions and situations.
• Limited Supply: Money should be in limited supply, so that it retains its value and does not become subject to inflation or devaluation.

The Money Supply

Money Supply: The total amount of money available in an economy at a particular point in time.

The money supply can be divided into two main categories: narrow money and broad money.

Narrow Money

Narrow money (M1) includes the most liquid forms of money, such as cash and demand deposits (current accounts). It represents the money that is readily available for transactions.

Broad Money

Broad money (M2, M3, etc.) includes narrow money as well as less liquid forms of money, such as savings accounts, time deposits, and other financial instruments. Broad money represents the total money supply in an economy, including both liquid and less liquid forms of money.

Money, Capital, and Foreign Exchange Markets

Financial markets can be divided into three main categories: money markets, capital markets, and foreign exchange markets.

Money Markets

Money markets are financial markets where short-term borrowing and lending of funds takes place, typically for periods of one year or less. They provide a mechanism for firms and governments to manage their short-term funding needs and for investors to earn a return on their short-term investments.

Capital Markets

Capital markets are financial markets where long-term borrowing and lending of funds takes place, typically for periods of more than one year. They provide a mechanism for firms and governments to raise long-term capital for investment and expansion, and for investors to earn a return on their long-term investments.

Foreign Exchange Markets

Foreign exchange markets are financial markets where currencies are bought and sold. They provide a mechanism for firms and governments to manage their foreign exchange risk and for investors to earn a return on their foreign exchange investments.

Main Functions of Financial Markets

To Facilitate Saving

Financial markets provide households and firms with a range of savings instruments, such as bank deposits, bonds, and equities. This allows them to earn a return on their savings and accumulate wealth.

As the Harrod-Domar model suggests, savings are a key determinant of investment and economic growth.

To Lend to Businesses and Individuals

Financial markets provide a mechanism for firms and households to borrow funds for investment and consumption. This can help stimulate economic activity and growth.

To Facilitate the Exchange of Goods and Services

Financial markets facilitate the convenient exchange of goods and services by providing a medium of exchange, such as money, and a mechanism for settling transactions, such as payment systems. These help to encourage more consumption.

To Provide Forward Markets in Currencies and Commodities

Forward and futures markets allow firms to trade commodities and currencies at a price agreed today for delivery in the future.

This helps firms hedge against price risk, reducing uncertainty and encouraging investment.

To Provide a Market for Equities

Equity markets allow firms to raise capital by issuing shares to investors. This provides businesses with the funds needed for expansion and investment.

Debt and Equity

Debt and equity are two main ways in which firms can raise capital for investment and expansion.

Debt

Debt refers to funds that a firm borrows from lenders, such as banks or bondholders. The firm is obligated to repay the debt with interest over a specified period of time.

Equity

Equity refers to funds that a firm raises by issuing shares to investors. Shareholders become part-owners of the firm and are entitled to a share of the firm's profits in the form of dividends.

Debt vs Equity

Bonds

Bond: A tradable debt security issued by a government or a firm in order to borrow money. The buyer lends the issuer a sum of money and, in return, receives a fixed interest payment each year plus repayment of the original sum on a set date in the future.

Bonds issued by the UK government are called gilts; those issued by firms are called corporate bonds.

Because they are usually long-term, bonds are traded on the capital market. Crucially, once a bond has been issued it can be bought and sold second-hand before it matures. This is why bonds have a market price that changes from day to day, and it is the key to understanding how interest rates affect them.

How Repayment Works: Bonds vs Bank Loans

Both a bond and a bank loan are ways of borrowing, but they are repaid very differently. With a typical bank loan the borrower makes regular repayments covering both interest and part of the principal, so the outstanding debt falls steadily and is cleared by the final payment.

With a bond, the issuer repays none of the principal during the life of the bond. It pays only the fixed annual coupon, and then repays the entire face value as a single lump sum on the maturity date.

Key Bond Terminology

Calculating Bond Yield

The coupon on the top of the fraction is fixed in cash terms for the entire life of the bond. Only the market price on the bottom can change. It follows automatically that if the price of a bond falls, its yield must rise, and if the price rises, its yield must fall.

Market Interest Rates, Bond Prices and Yields

Bonds compete with other savings and investment options. If interest rates elsewhere in the economy change, the price investors are willing to pay for a bond with a fixed coupon must change too. Suppose the Bank of England raises Bank Rate:

1. Savings accounts and newly issued bonds now offer a higher return.
2. Existing bonds still pay their old, lower fixed coupon, so they become relatively less attractive.
3. Investors sell existing bonds, so demand for them on the secondary market falls.
4. The market price of existing bonds falls.
5. Since the coupon is unchanged, that fixed payment is now a larger percentage of a smaller price, so the yield rises.
6. Prices stop falling once the yield has risen far enough to match the returns available elsewhere.

A cut in market interest rates works in exactly the reverse direction: the fixed coupon on existing bonds becomes relatively more attractive, demand rises, prices rise and yields fall.

There are therefore two relationships to remember. Bond prices and bond yields are always inversely related, while bond yields move in the same direction as market interest rates.

Why This Matters for the Economy

Gilt yields determine the cost to the government of financing its budget deficit. When yields rise, new borrowing becomes more expensive, debt interest absorbs a larger share of government spending, and the room for tax cuts or spending increases narrows.

Corporate bond yields matter in the same way for firms: higher yields raise the cost of raising long-term finance and can therefore reduce investment, lowering aggregate demand.