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The characteristics and functions of money
Money is a medium of exchange or a means of payment. It is also a store of value for future transactions.
Money serves two main functions in the economy as seen in figure 1 below:
Fig. 1 - Functions of money
- It's an exchange medium: in the old days, goods were traded through ‘barter’ (swapping). This wasn’t so effective as equally valuable goods or services were not always available for an exchange. With money, people can trade their products quickly without having to look for an equivalent item.
- It’s a value storage: money is an asset that allows people to store their wealth. However, inflation affects it and it devalues over time. An alternative to holding cash is purchasing financial assets such as bonds, shares, or physical assets such as a house or a piece of art.
Other functions of money include:
- A measure of value.
- A standard of deferred payment.
These two functions together are known as the unit of account function of money. Money is a unit that allows us to compare the relative values of goods and services in the marketplace. For example, a wooden writing desk costs £50 which is more costly than a £6 plastic table.
Deferred payment means that you can pay for something after the transaction is carried out. For example, you can place an order at a furniture store but only pay the invoice after the goods are delivered.
What are money markets?
Money markets are markets that facilitate the trading of short-dated financial assets (from one day to a year).
The assets are highly liquid. This means that they can be converted into cash quickly without losing value. Some examples include treasury bills and commercial bills (money market assets in the UK).
Money markets are the opposite of capital markets, which are also part of financial markets but deal with medium to long-dated financial assets.
To learn more about the difference between these two types of financial markets, check out our explanation on Capital Markets.
Why are money markets important
The money market exists to meet the need for short-term lending and borrowing by individuals, corporations, or the government.
It is less risky than the capital market as participants can trade high-quality debt securities (loans) for a short period of time, usually one year or less. Also, the securities are highly liquid and can be cashed out with ease.
Loans in money markets are often used by governments, banks, or large corporations (borrowers) to meet their short-term cash-related requirements. Individuals (savers) investing in these loans can expect a small interest at the maturity date.
Suppose you deposit £100 in your bank account. Instead of letting the money sit idle, the bank will lend it out to those in need and collect interest on the money lent, on your behalf. The party that borrows your money can use it for their own purpose such as paying business expenses or funding new projects.
Types of money market instruments
Money market instruments are split into two main categories: money market funds and money market accounts.
- Money market funds are mutual funds that invest in highly liquid and short-term debt instruments such as Certificates of Deposit (CDs), Commercial Paper (CP), Bankers' Acceptances (BA), and Repurchase Agreement (RP). These instruments are issued by banks, governments, and other large institutions and are thus, arguably, safer to invest in than equities issued by individual companies.
- Money market accounts are basically savings accounts that yield higher interest than a standard savings account. The issuer of money market accounts may limit the number of times the account holder can withdraw cash or write checks during the lending period.
Let's look further into some types of short-term securities.
Certificates of Deposit
A Certificate of Deposit (CD) is a special type of savings account where you deposit a large sum of money into a bank or credit union.
For a set period of, usually 3, 6, or 12 months, the depositors can’t access the money they have invested in the CD. Only when the certificates expire can they get back the principal along with some interest. CDs tend to offer a more attractive interest rate than the normal savings account.
Commercial paper
Commercial paper (CP) is a short-term debt instrument offered by a large corporation to cover its short-term financial needs.
To issue commercial paper, the firm must have an excellent credit rating to ensure it can pay back the face amount on the maturity date. The transactions are sometimes backed by the issuing bank.
Banker’s acceptances
Banker's acceptances (BA) are issued by banks on behalf of their account holders to guarantee payment.
A Banker’s Acceptance should include all the relevant details such as the issuing maturity date, the amount of money deposited, and the individual’s information. A banker's acceptance is mostly used in international trade to reduce credit risk between unknown parties. The maturity periods can range from 30 to 180 days.
Repurchase agreements
Repurchase agreements (RP), also known as Repo loans, are a debt instrument in which a financial institution sells securities to someone else with the promise to buy them again at a later date. In exchange, the buyer can earn interest on the purchase.
Repo loans are relatively safe as the securities traded tend to come from the government. Overnight repo loans have maturity as short as one day. However, both the buyer and seller can have the option to extend the period of the loan. In some cases, repurchase agreements have no expiry date at all.
To learn about UK money markets which comprise treasury bills and commercial bills, check out our explanation on Financial markets.
Functions of money markets
Money markets play many important roles in an economy, including:
- Providing funds for trading and the industry.
- Balancing the supply and demand in short-term financial transactions.
- Boosting economic growth by allowing corporations to access funds quickly.
- Providing the government with non-inflationary finance sources.
- Facilitating monetary policy implementation.
- Helping with the money creation process.
How do banks create money?
As your parents might have told you, money doesn’t grow on trees. It grows in banks! Banks are responsible for the creation of money through ‘bank deposits’.
Here’s how it works:
Every time you deposit a certain amount of money, instead of letting it sit idle, the bank will make loans to those in need, e.g. another individual, a company, or the government. Though banks don’t actually transfer money from your account to another account. They create new money (yes, out of thin air!) and deposit it into the borrower’s account.
To ensure the money is available in case of sudden withdrawals, banks hold a number of funds in reserves, known as reserve requirements.
Suppose you deposit £100 into the bank and the required reserve is £10, then the bank can only loan £90. Of course, the money in your account doesn’t go anywhere, but at the same time, the one who borrows £90 will also receive that money in their bank account. That’s the money created from thin air! In short, every time you make a deposit and that deposit is loaned out, new money is created.
To learn more about money creation, check out our explanation on banks.
Money market vs capital market
There are two primary differences between a money market vs capital market:
- First, money markets are associated with the lending and borrowing of securities in the short run, usually, one year or less, whereas a capital market supplies financial assets in the medium to long term (more than one year).
- Second, assets in money markets are mostly issued by governments or corporations to stabilize the cash flow. Investors only receive a modest return on investment. Meanwhile, a capital market is made up of shares and bonds which are riskier but come with potentially substantial yields.
Companies issue stocks (shares) in the capital market to raise funds for their operations or investments and almost anyone can buy them. Stocks have no expiry date, unlike short-term debt instruments such as CDs and CPs in the money market. Of course, unless the issuing company shuts down!
Money markets are, arguably, a main component of the financial market.
The existence of money markets is critical to an economy as it satisfies the need for short-term lending and borrowing in society.
Money Market - Key takeaways
- The money market facilitates the trading of short-term and highly liquid financial assets.
- The money market is important as it allows businesses, governments, and other financial institutions to meet their working capital requirement while generating interest for the investors.
- Money markets are made up of money market funds and money market accounts. Some examples of debt securities in the money market funds are certificates of deposits, commercial paper, bankers' acceptances, and repurchase payments.
- The main function of money markets is to boost economic growth by providing funds for corporations and balancing the supply and demand side in short-term financial transactions.
- A money market is a safer place to invest your money than the capital market as it deals mostly with short-dated securities. The capital market, on the other hand, supplies assets with medium to long-dated or undated maturities.
References
1. Hugh Patrick, Money Market, Britannica, 2018.
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Frequently Asked Questions about Money Market
What is the money market?
The money market is the market where people carry out the trading of short-term and highly liquid financial assets. In the UK, the primary financial instruments in the money market are treasury bills (issued by the government) and commercial bills (issued by commercial banks).
What is a money market fund?
A money market fund is a mutual fund that invests in highly liquid and short-term debt instruments such as Certificates of Deposit (CDs), Commercial Paper (CP), Bankers’ Acceptances (BA), and Repurchase Agreement (RP). These instruments are issued by banks, governments, and other large institutions and are, arguably, safer to invest in than equities issued by individual companies.
What is a money market account?
A money market account is basically a savings account that yields higher interest than a standard savings account. The issuer of money market accounts may limit the number of times the account holder can withdraw cash or write checks during the lending period.
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