Welcome to Financial Markets: Your Guide to the Engine Room of the Economy

Hello! This chapter might sound intimidating, but it is incredibly important. Financial markets are the "plumbing system" of the global economy. They take money from people who have extra (savers) and get it to people who need it (borrowers and investors).

Understanding this topic helps you link macro concepts like interest rates and inflation to real-world crises (like bank failures) and international trade. Don't worry if this seems tricky at first; we will break down the jargon into clear, digestible steps!

1. Characteristics and Functions of Money

Money is more than just colourful pieces of paper or numbers in a bank account. It is anything generally accepted as payment for goods and services.

Functions of Money (The Big Three)
  • Medium of Exchange (MOE): This is the most important function. Money eliminates the need for barter (swapping goods directly).
    Analogy: Instead of swapping your Economics book for a bag of rice, you sell the book for money, and then buy the rice with that money.
  • Measure of Value (Unit of Account): Money provides a common way to state the price of things. It allows us to compare the value of a car to the value of a coffee.
    Example: A coffee costs $5, a car costs $50,000. You know the car is 10,000 times more valuable because money gives it a clear unit.
  • Store of Value (SOV): Money holds its value over time, allowing you to save your purchasing power.
    Crucial Note: Inflation erodes this function. If prices double, your stored money buys half as much, making it a poor store of value.
Did you know?

The earliest forms of money included things like cowrie shells, large stone wheels (Yap), and salt! Anything durable and accepted can technically serve as money.

Key Takeaway: Money simplifies transactions, compares values, and allows us to save.

2. The Essential Role of Financial Markets

Financial markets are networks (physical or electronic) that connect those with surplus funds to those needing funds. Their primary roles are facilitating:

  • Saving: Providing institutions (banks, pension funds) for individuals to safely store money and earn a return (interest/dividends).
  • Lending: Providing funds to firms (for investment) and consumers (for mortgages, credit cards).
  • Exchange of Goods and Services: Payment systems rely on stable financial institutions.
  • Insurance: Managing and pooling risk (e.g., insuring homes or businesses).
Debt vs. Equity

When firms or governments need money, they mainly use two methods:

  • Debt: The borrower promises to repay the original amount (principal) plus interest at a fixed time.
    Example: Loans or Bonds (a certificate promising repayment). Debt holders are creditors.
  • Equity: Funds raised by selling shares of ownership in the company. The buyer becomes a part-owner and receives a share of profits (dividends).
    Example: Shares or Stocks. Equity holders are owners.

Quick Review: Debt is a promise to pay back; Equity is giving up ownership.

3. Types of Financial Markets

Financial markets are typically categorized by the time horizon and type of asset traded.

Money, Capital, and Foreign Exchange Markets
  • Money Market: Trades assets that are highly liquid and short-term (usually less than a year). These markets deal with day-to-day liquidity needs.
    Example: Commercial paper, short-term government treasury bills.
  • Capital Market: Trades medium- to long-term financial assets. This is where large companies raise the long-term funds needed for growth.
    Example: The Stock Market (equity) and the Bond Market (long-term debt).
  • Foreign Exchange (FX) Market: Where currencies are bought and sold. This is essential for international trade and investment.
Spot and Forward Markets
  • Spot Market: Deals with transactions for immediate delivery (on the spot).
    Example: Changing currency at the airport for today's travel.
  • Forward Market: Deals with contracts to buy or sell an asset (currency or commodity) at a specific price, on a specific future date. This is used by firms to hedge (protect themselves) against future price fluctuations.
    Example: An airline agrees today to buy jet fuel at a fixed price six months from now, ensuring their future costs are predictable.

4. Financial Institutions: Banks and the Central Bank

The financial system is complex, but we focus on the core institutions and their differences.

Commercial Banks vs. Investment Banks
  • Commercial Banks (Retail Banks): These are the "High Street" banks you use every day. Their primary function is taking deposits and making loans (mortgages, business loans). They focus on stability and liquidity.
  • Investment Banks: These banks focus on corporate finance. They help large companies issue shares (Initial Public Offerings - IPOs), issue bonds, advise on mergers, and manage complex trading activities. They engage in much higher-risk activities.

Note: In many modern financial systems, banks often combine these activities, leading to universal banks. This increases efficiency but also raises systemic risk (the risk of collapse spreading throughout the whole system).

Why a Bank Might Fail (The Risks of Mismatch)

The core problem for banks is the mismatch between their borrowing and lending terms:

  • Lending Long: Banks often lend money out for long periods (e.g., a 25-year mortgage).
  • Borrowing Short: They borrow that money from depositors, who can often demand it back very quickly (e.g., instant access savings accounts).

If too many depositors demand their money back at once (a bank run), the bank cannot sell off its long-term assets fast enough to repay everyone, leading to failure.

The Central Bank and its Functions

The Central Bank (like the Bank of England or the US Federal Reserve) is the government's bank and the bank for all other banks.

  • Monetary Policy: Controlling inflation using interest rates and quantitative easing (QE).
  • Supervising the Banking System: Ensuring banks are safe and stable.
  • Lender of Last Resort (LoLR): If a stable commercial bank faces a panic (a bank run) but is fundamentally solvent (it has more assets than liabilities), the Central Bank will lend it money to prevent collapse and restore confidence.
  • Reserve Ratios: Central banks can set the Required Reserve Ratio, which is the fraction of deposits that commercial banks must hold in reserve. Increasing this ratio reduces the money supply and influences stability.

5. Market Failures and Instability in Financial Markets

Financial markets are prone to failure because of the complexity and the information gaps involved.

Asymmetric Information and Moral Hazard
  • Asymmetric Information: This means one party in a transaction has more information than the other. This can lead to poor decision-making and market failure.
    Example: When a bank lends money, the borrower knows more about their ability (or likelihood) to repay the loan than the bank does (this is also called adverse selection).
  • Moral Hazard: This occurs when one party changes their behaviour after a contract is agreed upon because they are protected from risk.
    Example: If a bank knows the Central Bank will bail them out (LoLR), they might take excessive risks, knowing they won't bear the full cost of failure.
Speculation and Market Bubbles

Speculation involves buying an asset purely in the hope that its price will rise, allowing a quick profit. Speculation can be:

  • Stabilising: Speculators buy assets when they think the price is too low, pushing the price back up towards the fundamental value.
  • Destabilising: Speculators buy assets simply because the price is rising, creating artificial demand and driving the price away from the fundamental value. This leads to Market Bubbles.

A Market Bubble occurs when the price of an asset (like housing or stocks) rises far above its true economic value. Eventually, when confidence collapses, the bubble bursts, leading to sharp price drops and financial crises (e.g., the 2008 housing crisis).

Herding Behaviour

This is when investors ignore their own analysis and follow the actions of a large group, often based on emotional panic or irrational exuberance. This behaviour exacerbates destabilising speculation and accelerates the formation and collapse of bubbles.

The Shadow Banking Market

These are financial institutions (like hedge funds, private equity firms) that perform banking functions (credit intermediation) but are not subject to the same strict regulation as traditional commercial banks. They increase the complexity of the system and pose hidden risks.

Systemic Risk and the Real Economy

Systemic risk is the risk of collapse of the entire financial system or market, as opposed to the collapse of a single firm. Because all major financial institutions are interconnected, the failure of one huge bank can cause a domino effect throughout the whole economy.

When financial markets collapse, lending freezes, investment stops, consumer confidence plummets, and the country faces a severe recession or depression in the real economy (the economy of goods and services).

6. Regulation of Financial Markets

Given the huge risks (systemic risk, moral hazard, market bubbles), financial markets must be regulated.

  • Regulation aims to ensure banks hold enough capital (money) to cover potential losses and to enforce transparency to combat asymmetric information.
  • Other key players, like pension funds and insurance companies, are also heavily regulated because they manage vast amounts of public savings, impacting long-term economic stability.

Super Summary (The Financial System Checklist): Financial markets connect savers and borrowers through debt and equity. Banks (Commercial and Investment) manage this flow, overseen by the Central Bank (LoLR). Instability arises from information failures (asymmetric info, moral hazard) and irrational behaviour (speculation, herding), which can trigger systemic risk and damage the real economy.