Understanding the Financial System and Monetary Policy
The Financial System
The financial system encompasses laws, institutions, assets, and markets that channel savings into investments. It involves institutions mediating between those offering and those demanding financing.
Financial Intermediaries
These institutions receive money from savers and lend it to those needing funds. They facilitate the flow of savings between savers and investors, charging interest to borrowers and paying interest (at a lower rate) to savers.
Financial Assets
Assets represent stored wealth and can be categorized into:
- Real Assets: Physical items like houses, jewelry, and land.
- Financial Assets: Non-physical items like bank deposits, investment funds, and treasury bills.
Unspent income can be saved and held in these assets. Assets are any good or right that provides a yield to its owner.
Characteristics of Financial Assets
Key features to consider when choosing a financial asset include:
- Liquidity: The ability to quickly convert an asset into cash. Higher liquidity typically means lower returns.
- Risk: Uncertainty about the asset’s future value. Higher risk often correlates with higher potential profitability.
- Profitability: The return or compensation provided by the financial asset.
Financial Markets
Financial markets facilitate the buying and selling of financial assets, connecting buyers and sellers, often through financial intermediaries. However, direct interaction between buyers and sellers is also possible.
Types of Financial Markets
- Credit Market/Stock Market:
- Credit Market: Banks and savings institutions capture resources from savers and offer them as loans or credit.
- Stock Market: Entities raise funds by issuing bonds or securities traded on exchanges.
- Primary Market/Secondary Market:
- Primary Market: Trades newly created assets, such as the initial issuance of a stock.
- Secondary Market: Trades existing stocks and other securities after their initial issuance.
- Money Market/Capital Market:
- Money Market: Trades short-term financial assets with maturities of less than one year.
- Capital Market: Trades long-term financial assets with maturities of more than one year.
Monetary Policy
The European Central Bank (ECB) formulates and implements monetary policy. Its goal is to control the money supply to influence prices, GDP, employment, and exchange rates.
Instruments of Monetary Policy
- Discount Rate: The interest rate set by the ECB for commercial banks. Increasing this rate encourages saving and reduces the demand for money.
- Reserve Ratio: The amount of reserves commercial banks must hold. Increasing this ratio reduces the money supply.
- Open Market Operations: Buying or selling government debt instruments to influence the money supply. Selling debt decreases the money supply.
Objectives of Monetary Policy
- Intermediate Objectives: Interest rates and money supply.
- Ultimate Goal: Price stability, GDP growth, low unemployment, and exchange rate stability.
Types of Monetary Policy
Expansionary Monetary Policy
Used during recessions to stimulate the economy by lowering interest rates, encouraging investment and consumption, and increasing aggregate demand, income, and employment.
Restrictive Monetary Policy
Used to control inflation by increasing interest rates, reducing consumption and investment, and lowering aggregate demand.
EU Monetary Policy
The ECB designs monetary policy, and national central banks implement it. The European System of Central Banks (ESCB) comprises the ECB and central banks of all EU member states. The Eurosystem includes the ECB and central banks of eurozone countries.
Functions of the Eurosystem
- Define and implement EU monetary policy.
- Hold and manage foreign exchange reserves.
- Apply banking regulations.
- Issue banknotes.
The primary objective of the ESCB is to maintain price stability, prioritizing inflation control above other objectives.