Understanding Money, Inflation, and Financial Markets

Posted on Dec 10, 2024 in Economy

Functions of Money

Money serves three primary functions:

  1. Medium of Exchange: It acts as an intermediary, facilitating trade and specialization in production.
  2. Store of Value: It provides a means to maintain and save wealth.
  3. Unit of Account or Measure: It’s used to measure the value of goods and services.

Monetary Aggregates

Monetary aggregates are categorized as follows:

  1. Cash in the Hands of the Public: Notes and coins in circulation.
  2. Money Deposited in Banks: Banks hold money for safekeeping and convenience.
  • Overnight Deposits or Current Accounts: Offer immediate availability.
  • Savings Deposits or Savings Accounts: Offer less availability than current accounts and typically do not allow the use of checks.
  • Fixed-Term Deposits: Money is deposited for a fixed period, and early withdrawal may incur a penalty.

Demand for Money

The demand for money arises from several motives:

  • Transactions Demand: Families and businesses need money for everyday purchases.
  • Precautionary Demand: Economic agents hold money for unexpected expenses.

Factors influencing the demand for money include:

  • Price Level: Higher prices require more money for the same transactions.
  • Income Level: Increased income often leads to increased expenses, thus demanding more money.
  • Interest Rates: There’s an inverse relationship with the demand for money; lower interest rates on fixed-term deposits or bonds may increase the demand for cash, and vice-versa.
  • Risk and Expectations: Holding cash can be perceived as safer than investing, especially during times of uncertainty.

Cash Ratio

The cash ratio refers to the reserves that banks must hold to meet customer withdrawal requests.

Interest Rates

The interest rate is the price of a loan, representing the cost of borrowing money. Borrowers pay interest as compensation for:

  • The lender forgoing the right to use the money during the loan period.
  • The lender taking on the risk of non-repayment.
  • The potential loss of the money’s value due to inflation.

Factors influencing interest rates, as set by the European Central Bank (ECB), include:

  • Duration: Longer loan terms typically command higher interest rates.
  • Risk: Higher perceived risk of non-repayment leads to higher interest rates.
  • Liquidity: The easier it is to convert an asset to cash, the lower the interest rate.

Inflation

Inflation is a sustained and general increase in prices.

Types of Inflation

  • Moderate Inflation: An increase of less than 2-3%.
  • High Inflation: An increase above 10%.
  • Hyperinflation: An increase of over 100% in a year, leading to a loss of control over prices and a breakdown of the monetary system. In such cases, people may resort to bartering.

Causes of Inflation

  1. Demand-Pull Inflation: Excess demand leads to price increases. This can be interpreted in two ways:
    • Monetarist View: If the money supply grows faster than the production of goods, people have more money to buy the same amount of goods, leading to higher prices.
    • Keynesian View: When an economy’s resources are fully utilized, and production cannot increase further, consumers may pay more for the available goods.
  2. Cost-Push Inflation: Rising production costs, such as wages, raw materials, and energy, can drive up prices.

Effects of Inflation

  • On Production and Employment: Uncertainty in the economy can negatively impact production, economic growth, and employment, reducing international competitiveness.
  • On Income Distribution:
    • Savers and Borrowers: Savers are hurt as the value of their savings diminishes, unless interest rates are adjusted to compensate for inflation.
    • Weaker Groups: Those who cannot negotiate wage increases in line with inflation are negatively affected.
    • Borrowers: Borrowers may benefit as they repay loans with money that has less purchasing power.
    • Asset Holders: Asset holders may benefit as the value of their assets may increase with inflation.

Nominal variables do not account for inflation, while real variables are adjusted for inflation.

Financial Intermediaries

Banking Financial Intermediaries

These include banks, savings banks (non-profit organizations dedicated to social welfare), and credit cooperatives.

Non-Banking Financial Intermediaries

  • Investment Companies and Funds: Sell shares to the public and use the proceeds to buy a portfolio of stocks and bonds.
  • Pension Funds: Collect money from active workers and invest it to provide retirement benefits.
  • Insurance Companies: Provide financial coverage for risks, profiting from customer premiums.
  • Leasing Entities: Finance companies that rent property with an option to buy.
  • Factoring Entities: Collect outstanding invoices or credits from third parties.
  • Venture Capital Entities: Provide temporary capital to companies, expecting a return when the companies grow.

Characteristics of Financial Assets

  • Return: The yield an investor receives, which can be fixed or variable.
  • Risk: The uncertainty of recovering the investment.
  • Liquidity: The ease with which an asset can be converted into cash.

Ensuring the Functioning of the Stock Market

  • Securities Market Act: Establishes the legal framework for the markets.
  • National Securities Market Commission: A public agency that guarantees market transparency, correct asset price formation, and investor protection.
  • Stock Market Indices: Reflect the evolution of stock prices over time. For example, the IBEX 35 shows the evolution of the 35 most actively traded companies.
  • Market Capitalization: The number of shares multiplied by their current price. Investors earn through dividends and capital appreciation from selling shares.

Basic Functions of the Eurosystem

  • Define and implement the single monetary policy for the Eurozone.
  • Manage the official foreign reserves of the Eurozone.
  • Issue legal tender notes.
  • Ensure financial system stability.
  • Objective: Price stability.

Monetary Policy Instruments of the EMU

  1. Open Market Operations: 15-day loans provided by the ECB to banks.
  2. Reserve Requirement: Banks must hold a certain percentage of deposits as reserves (currently 2%).
  3. Permanent Facilities: Institutions can borrow money for liquidity needs or deposit excess funds to adjust their reserve ratio.

Monetary Policies

  • Expansionary Policy: Aims to stimulate economic growth. The ECB may increase the money supply through auctions or lower interest rates, boosting consumption and investment, which increases aggregate demand. However, the monetary authority must also consider price stability.
  • Restrictive Policy: Used to curb inflation. The ECB may reduce the money supply, raise interest rates, or increase the reserve requirement to reduce spending and control prices.