Money banking and financial market refers to the recently developed financial structure of most economies.
Money in simple terms refers to a medium that is used to exchange goods and services. But circulation of money is controlled by banks performing money banking and financial markets. Money banking and financial market is a crucial part of the present economic system.
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Money banking and financial market: an overview
Money:
Money consists of paper money, coins and bank deposits. Nowadays credit cards and electronic cash have become an integral part of the payment system.
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Uses of money:
Money refers to the notes and coins that act as a means of transaction and accounts for debits and credits. Buying and selling would be impossible without it. Generally the worth of a commodity is decided by the amount of money one has to pay for it but this doesn't imply that the real value of a good is the same as its monetary cost. This principle was popularized as the 'paradox of value' by famous economist Adam Smith.
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Water is essential for life but is free of cost whereas diamonds have little use but command high prices. Smith pointed out that scarcity is a more important determinant of price than utility. Thus money replaced the barter system as it is the most liquid asset available in the market as it is easily traded and has low transaction costs.
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Money is also a store of value. Money can be reliably saved, stored and recovered. The notes and coins have no relevance except that they aid exchange. Money can't earn interest on itself unless invested somewhere. Money can be looked upon as an efficient store of value as it is durable and does not perish easily, imitation and creation of fake money is very difficult and the actual form of money can be easily recognized. The value of money remains almost stable over years. Variation in its value is possible but is usually negligible.
Money is the most accepted and standard unit of account for measure of relative worth of goods and for clearing deferred payments.
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It is possible to assume money as a reliable unit of account as it is available in smaller denominations and the value of the material used for making it is less than its face value.
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Creation of money:
Money (currency) is issued primarily by the central bank of a country, the premier body bestowed with the responsibility of currency management. Commercial banks of a country also play an important role in the creation of money and the process is extremely simple.
A bank has a number of depositors who deposit money in the bank. The total money the bank has in its accounts is known has liquid assets. When the bank grants loan to a person, an account is created in his name and it is debited by the amount of loan. The bank counts the amount as its assets. The amount in the depositor's accounts are however not disturbed. In this process the bank's obligations increase by double the amount of the loan granted. This is because the borrower can default and the depositors may ask for their money.
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The loan is spent by the borrower to meet his needs and thus the depositor's money now gets transformed into 'new money' in the economy. This new money then circulates through the economy. Some people also put part of this money into their deposits which is again lent out and so on. Thus a huge proportion of the money in circulation and those in deposits was actually created through loans granted by banks. Thus commercial banks have a great role in inputing huge sums of money into the economy.
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Money Supply:
Money supply is basically the amount of money that circulates in the economy at any point of time. It includes paper currency, coins and checking accounts. There are basically three definitions of money supply:
M1 money supply- This is the most primitive definition of money supply. It says that money supply consists of cash held by the public, regular demand deposits and checking account balances and balances in NOW(Negotiable Order of Withdrawal) accounts and credit unions.
M2 money supply- This includes all those sources included in M1 and in addition includes saving deposits and small time deposits. Besides it also includes non-institutional money market accounts and repos (of maturity greater than one day) conducted at banks.
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M3 money supply- this includes all sources covered by M2 and also takes into consideration large time deposits, institutional money markets and repos that are not included in M2. M3 is the broadest definition of money.
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Money Supply is crucial for an economy because:
Money finances all transactions thus enhancing economic activity. The increased availability of money (due to the constant flow from central banks) circulates through the economy in a cycle. The extra money goes into the hands of consumers thus increasing their purchasing power and compelling businesses to utilize their idle capacity to meet the wants. Producers hire more people and capital and thus induce additional purchasing power in the economy. Such a bright future in turn boosts stock prices and help firms raise money using debt and equity.
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But increasing money supply can have adverse impact on the economy when industrial production touches its ceiling. Under such circumstances excess demand leads to inflation and thus erodes the real value of money. This is the famous 'quantity theory of money' by Friedman. Lenders start charging a higher rate of interest as inflation reaches a substantial level. An inflationary situation leads to future expectations of price rise thus increasing present demand and an undesirable situation culminating into hoarding and black marketing. So maintaining a decent growth in money supply is imperative.
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Balancing the money supply:
Federal reserve policy dictates the fraction of deposits of commercial bank that has to be kept as reserves in cash at their vault or as deposits with the central bank. The federal reserve also performs open market operations to manipulate reserves. The federal reserve thus has the power to control both currency and bank reserves. The Federal Reserve uses both techniques-borrowed and unborrowed reserves to finely achieve the optimal growth in money supply. The interest rate mechanism and the price adjustment also help to achieve the desired growth in money supply.
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Amount of money in an economy may increase or decrease. There is a boom when there is abundance of money and a slump is caused by scarcity.
Banks:
In simple terms a bank is a type of financial institution that accepts deposits and makes loans. Deposits in bank are the most essential form of money in any economy. People tend to save in a bank in different forms. Some of the accounts that are most common include savings accounts, checking accounts, bank money market deposit accounts(MMDA), CD(certificates of deposits), and IRA(Individual Retirement Account). The chief sources from which a bank derives money are checks, drafts etc deposited in the bank. This money is credit to the account of the holder but is ultimately held by the bank Following are the most common accounts available in most bank:
Savings Accounts- Savings accounts are insured by FDIC(Federal Deposit Insurance Corporation). These promote saving out of present consumption for using in some future period. The saver can expect a higher income at some later period as the savings accounts are subject to rate of interest. He can withdraw a limited portion of his saving at times using ATMs and checks. The concept of saving accounts for kids has also been introduced so as to inculcate saving habits in children. money deposited in the savings account is the primary source of money in most banks.
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Checking Accounts- This account has both its pros and cons over savings accounts. A checking account holder has the facility of unlimited withdrawals using checks, ATM or transfers. However checking accounts usually don't pay any interest. Thus depositing money is almost similar to holding money idle. Some banks pay interest for deposits in checking accounts but the interest rate is just enough to compensate for the transaction costs. A monthly service fee is deducted in case the balance comes down a predetermined level. Checking accounts are usually NOW (Negotiable Order of Withdrawal) accounts thus making the customer eligible for a VISA Check Card.
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Certificates of Deposits- Banks provide their customers with a special type of deposit account known as CD which pays interest that is higher than even a savings account. CDs are insured by federal deposit upto $100,000. A CD gives an opportunity for investing an amount for a fixed period of time of 6months, 1year, 5year etc. at the time of maturity the bank returns the principal as well an interest that has accrued over time. In case of redemption before maturity , the bank usually deducts a portion of the interest rate that the CD has earned. This is widely known as 'early withdrawal' fee. In recent years there has been a reform in the market for CDs. CDs nowadays feature variable rates, call options and special redemption features in case of death of the investor. Individual and institutional CDs start from $100 and $100,000 respectively.
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Money Market Deposit Account- MMDA is a particular type of savings account that offers competitive rates of interest and the deposit amount is usually higher than those in savings account. Federal laws insure the MMDAs. MMDAs are safer than investing in the stock market. MMDA is the most suitable place to store the money that has been earned from some other investment. But the demerit of investing in a MMDA is that one can make only limited transaction in the order of five or less thus inviting only long term investors.
Individual Retirement Account- an IRA is one of the most suitable options provided by the Federal government to encourage people to save for retirement. It carries with it the benefit of compound interest and tax savings. There are 11 types of IRA available in the market. The two most common types of IRA provided by banks are Roth IRA and Educational IRA. Roth IRA is mainly concerned with tax-free distributions whereas the Education IRA helps investors bear the usual college expenses. An IRA holder can be 18 to 70 ½ years old. An IRA holder can start withdrawing money once one has crossed the age of 59 ½ years. Federal laws insure all IRA funds up to $250,000.
Demand Deposit- commercial banks provide checking accounts known as demand deposits on which no interest can be earned. These are demand deposit accounts that are payable on demand i.e without prior notice. The account holder benefits through cashless transactions i.e he pays by means of checks, drafts, electronic funds etc.
The outflow of money from bank- the Efflux
Loan are made by an organization or a person (a lender) to another person or organization (borrower). Its the obligation of the borrower to repay the loan and interest accrued in installments or as a whole during or after the term of the loan. Money deposited in the bank by depositors flows out to those who need it most as their penury doesn't allow them to fulfill their desires. The process of lending, borrowing and repaying is based on the terms and conditions laid down by the lenders. The bank bears the whole risk and has to credit the depositor's account from its own funds. So the bank keeps the asset of the borrower as collateral. Some of the most common form of loans are:
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Home Loan- The home loan is the most popular loan in US as most Americans wish to have their own house. Home loan offers the customer to purchase the desired private dwelling. A home loan is also useful in case one wants to modify his home in order to have a decent living standard. The lender returns the title or deed once the loan (and interest) is repaid in full.
Automobile Loans- An automobile loan (auto loan) aids purchase of a car. There are varieties of loan options and rebates available but one must be careful in choosing the loan provider as there are many factors determining the rate of loan such as the term of loan, the credit history of the borrower etc. the APR(Annual Percentage Rate) is usually accepted as the best rate that can be used for comparative analysis of loans. The vehicle bought is usually treated as the collateral thus generating the minimum incentive for moral hazard(imprudent default) to arise. Loans can be taken to purchase new as well as used cars. The borrowers repay the loan and accruing interest along the term of loan by making periodic payments(for five to six years).
Home Equity Loan- This loan lets the house-owner an opportunity to exploit their existing home and get money for meeting other expenses (that are urgent) such as paying for education and medical bills.
Besides loans, credit cards also serve a huge proportion of the US population. A huge number of cards are provided by almost all banks. These not only provide quick access to money but also relieves the user from carrying huge amount of cash. Credit card are very useful but certain things should be kept in mind such as an unfortunate loss, theft or mutilation of a credit card can land the card holder in a mess.
Customers are the most valuable assets for bank:
A huge chunk of the bank's earning is made out of the customer. A bank provides diversified ways to a person ensure that his money is kept in a safe place. The customer is also benefited as the money doesn't simply lies idle but also(usually) earn interest over time. Account holders tend to ignore the fee charged by banks for its services. The fee in most cases is substantial. Researches have shown that a checking account alone can cost a person $200-250 a year. In addition there are fee for checks and ATM fee. Thus banks dig deep into the pockets of investors without even letting them know.
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Financial Market:
A financial market is simply a market where buyers and sellers of a financial instrument (equity, debt, checks or drafts) meet and exchange capital and credit in an economy. Financial markets like other markets can also be organized or unorganized. Financial instrument is a document that has a transfer or monetary value and can be available ready made either in a physical or electronic form. Financial markets can be broadly classified into two groups:
Money Market- Money Market deals with institutions and practices pertinent exclusively to short term debt instruments. It goes beyond the procedure of issuing bank notes with the main aim to facilitate short-term lending and borrowing. Money market is a part of the fixed income market and specifically deals with very short term debt securities (less than 1 year). So money market investments are also referred to as cash investments. The securities are usually highly liquid and safe government and large corporations IOUs. These trade in very high denominations but the rate of interest is usually low. The firms use their own accounts to buy and sell securities thus bearing the risk themselves. The different instruments of money markets are Treasury Bills, CDs, Commercial Papers, Banker's Acceptance, Repos, Eurodollars etc. However a money market mutual fund or a money market bank account is usually the easiest way to enter a money market.
Capital Market- A capital market usually deals with medium and long term securities and capital market instruments are traded usually at banks, insurance markets, bond markets and stock exchanges. The instruments are bought and sold on the accounts of the stock holders. Shares and bonds are issued by government, corporate borrowers and financial institutions.
