Financial Markets (AQA A Level Economics)

An Introduction to Money

• Prior to the creation of money, individuals and firms had to accept other goods or services as payment or be self-sufficient by producing everything required

• Often lacking self-sufficiency or driven by the desire for a wider range of goods/services, bartering became the norm, but it too had problems

• As individuals and firms trade with each other in order to acquire goods or raw materials, they require a means of exchange that is acceptable and easy to use
   

• Modern currency fulfils this purpose, and money functions as a medium of exchange, a measure of value, a store of value, and a method of deferred payment
  

  The four Functions of Money

The Characteristics of Money

• Many items were used for centuries as a form of money such as gold, silver, shells, beer, tobacco

• However, each one of these items had some characteristics that made them less than ideal for exchange in certain circumstances

• Good money has a number of essential characteristics - and modern currency fulfils them all

Diagram: The Characteristics of Money

1. Divisibility: to be a valued medium of exchange, currency must be divisible. €50 notes can be exchanged for €10 euro notes or €1 coins

2. Acceptability: the currency must be valued and widely accepted by society as a valid way to pay for goods/services

3. Durability: the currency must be robust, not easily defaced or destroyed, and last for a long period of time

4. Scarcity: the supply of the currency should be such that it remains desirable and retains its value in the market. Oversupply would decrease its worth

5. Uniformity: in order to be a valid measure of value, each denomination must be exactly the same, e.g. every $50 note must be exactly the same

6. Portability: good currency is easy to carry or conceal

The Money Supply, Narrow Money & Broad Money

• Money supply refers to the total financial assets functioning as money within an economy

• The money supply is broken into different types of money

  • Demand deposits are funds held in a checking account that account holders can withdraw at any time without prior notice

  • Near money assets are savings deposits, money market funds, and other financial instruments that, while not directly functioning as currency, are highly liquid and easily convertible into cash or used for transactions

  • M0 includes physical currency and central bank reserves

  • M1 encompasses currency in circulation and demand deposits 

  • M2 consists of M1 plus savings deposits and similar near-money assets

  • M3 includes M2 along with large time deposits and institutional money market funds
    

The distinction between narrow money and broad money

Narrow money

• Is part of the money supply made up of cash and liquid assets from banks and building society deposits

  • Its primary role is to function as a means of payment 

Broad money

• It is part of the money supply, comprising of cash, liquid assets from banks and building society deposits, and also [popover id="6aic1Am7Z87QoU8V" label="illiquid assets"]
  

• Liquidity measures the ease in which an asset can be converted into cash

  • An example of an illiquid asset is a house, which requires a considerable amount of time to be transformed into cash

  • Shares are illiquid but are more easily sold

  • Cash is the most liquid of all assets 

Role of Financial Markets

• Financial markets are any place or system that provides buyers and sellers the means to exchange goods/services and trade financial instruments

  • These include bonds, equities, international currencies and derivatives

1. They facilitate saving: storing money for future use is essential for households & firms. It also provides a pool of money that financial institutions can lend, i.e. one person's savings is another person's borrowing
   

2. They lend to businesses & individuals: access to credit is a key requirement for economic growth & development. Being able to borrow money speeds up consumption by households & investment by firms. It also allows households or firms to purchase assets & pay them off over an extended period of time, e.g. mortgages on home purchases
   

3. They facilitate the exchange of goods & services: each purchase of goods/services requires the movement of money between at least two parties. Financial markets provide multiple ways for this exchange to happen, including phone apps (Google Pay), debit cards, credit cards & bank transfers
   

4. They provide forward markets in currencies & commodities: forward markets are also called futures markets. They provide some price stability in commodity markets and enable investors to make a profit by speculating on future prices
   

5. They provide a market for equities: equities are shares in public companies that are listed on stock exchanges around the world. Financial markets facilitate both long term investment and speculation by providing platforms which connect buyers and sellers e.g. E-Trade

Money, Capital & Foreign Exchange Markets

• The three main financial markets are the Money Market, The Capital market, and the Foreign Exchange Market

Diagram: Types of Financial Markets

An Explanation of each Financial Market