The role of monay and financial markets

Money as a medium of exchange

A medium of exchange is anything that sets the standard of value satisfactory to all parties in a transaction. Money solved a problem with the old system of barter. It makes it easier to barter for items of inequal value. It is generally backed by the government and has anti-counterfeit measures providing confidence to all parties about its value.

Money includes notes, coins, and deposits in savings and current accounts. An important distinction should be made to debit and credit cards which provide access to your accounts but are not in themselves considered money.

The role of the financial sector

Financial institution	Role in the financial sector
Reserve bank	Every country has a reserve bank. In the UK this is the Bank of England. They do not accept deposits and make loans like a regular bank. They issue bank notes. They control monetary policy through the monetary price committee who meet regularly to set the bank rate. This is the rate at which they will hold deposits for banks and loan them additional funds. They provide financial stability by overseeing the financial sector. One method for this is requiring financial institutions to hold a certain amount of their deposits with the reserve bank. When the country wants to affect the currency exchange rate the reserve bank controls the countries foreign reserves. If the government is looking to raise funds or pay off debt it is done through treasury bonds bought and sold by the reserve bank.
Commercial banks	Commercial banks accept deposits from customers and in return provide security and possibly a small amount of interest. They use this money to offer loans to customers who need money. They will charge a higher percentage for this than what they offer for deposits. This is were their profits come from. They also provide services for which there may be account charges. These include things like allowing direct debits, accepting cheques,
Building societies	Building societies provide similar services to banks. They accept deposits and provide current and savings accounts and they provide loans. The key difference is that building societies are not companies but rather mutual institutions. These are businesses that are run for the benefit of their members. Members have a right to speak at meetings and have a say in the running of the building society. The primary aim of building societies is to provide mortgages which are loans to purchase houses.
Insurance companies	Insurance companies provide compensation for specified loss, damage, illness or death in return for regular payments known as premiums. This can include coverage for losses from theft or damage from things like floods and fires. Life insurance provides payouts when someone dies and businesses can also get key worker policies that cover them for losses in the event of losing a key member of staff. Insurance helps provide security and certainty.

The importance of the financial sector for consumers, producers and government

For consumers

The financial sector provides savings products and loans both of which can help consumers to afford big ticket items. They provide liquidity in the form of overdrafts and credit cards to allow consumers to handle short term cash flow issues. They also allow easy access to savings through services such as debit cards, phone payments and direct debits. They allow people to insure expensive items so they can be confident that they will get the full use out of them without fear of the products breaking or being stolen. The financial sector also allows individual consumers to pool their resources through managed savings funds so that they can have a diversified investment. This means instead of having to invest in just one company, they are invested in a range so they are not as reliant on the success of any one company.

For producers

Producers can similarly use savings products and loans to enable them to invest and expand. They also benefit from overdrafts and other forms of short term finance to assist them with cash flow problems. This can be very important for firms who have a long delay between when they pay for inputs and when they are paid for their product. The financial sector provides a number of payment services to allow business to accept card payments and online transactions. Businesses have a lot of expensive assets and insurance provides certainty that if they are damaged or stolen they will be replaced. Smaller firms who can't afford to diversify their own investments might also make use of managed funds.

For the government

The financial sector helps move money from savers to borrowers. This enables growth in the economy as these borrowers invest the money. It provides trust through the role of the reserve bank and certainty through insurance. The government uses the financial sector to borrow money through issuing treasury bonds. The provision of liquidity helps businesses to continue to function and this boosts the economy.

How different interest rates affect the levels of saving, borrowing and investment

Effect on:	Increase in interest rates	Decrease in interest rates
Savings	As interest rates rise you would expect more people to want to save because the reward for saving has gone up. This is generally the case but some may not be able to spare any additional money to save and people will still have a demand for big ticket items like homes and cars.	As they fall you would expect savings to fall and they most likely will. The opportunity cost of spending is lower because they will not miss out on as much interest. However some of those people that are saving for a particular purpose like a house deposit or a car will still want to save regardless of the lower rates.
Borrowing	As interest rates increase so does the cost of borrowing. This means less people will be willing to borrow. However some firms that feel they can make more money by investing than they will pay in interest and individuals with specific needs like housing and cars will still need to borrow for these reasons even at higher interest rates. If interest rates are rising here but not elsewhere, the pound will likely appreciate and this will mean exports from the UK become more expensive. Because of this firms will be less likely to grow.	When interest rates decrease it costs less to borrow and so more firms and consumers are willing to. However, people will not borrow unless there is a valid reason and some people are averse to the idea of credit. The perception of what the future is likely to hold can also affect the decision to borrow as if people think the economy may go into a downturn then firms will be less willing to borrow to invest and consumers will be more likely to save than spend.
Investment	This refers to firms investing in capital equipment which they would do either through loans or by using their retained profits. If interest rates go up the cost of borrowing goes up and so to does the opportunity cost of investing retained profits because more interest could be made by saving them. Together these mean that higher interest rates lead to lower investment. If businesses think things may soon improve in the economy then they may still be willing to invest.	When interest rates go down so to does the cost of borrowing to invest and the opportunity cost of using retained profits. Together these mean that when interest rates are lower investment will be higher. If firms are concerned for the future economic outlook then even lower interest rates may not encourage investment.

Calculating the effect on savings and borrowings of changes in the rate of interest

Questions of this type will only involve you having to calculate the amount of interest per annum based on a yearly rate. If it is the interest on a loan then you will be working out how much more people will be paying each year and if it is interest on saving it will be how much extra they receive. Use the area below to generate questions that will ask you to calculate the difference in interest:

Click the button below to generate a question to practice calculating gross and net pay

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Questions

Explain what is meant by money as a medium of exchange. (2 marks)

A medium of exchange is anything that sets the standard of value of goods and services(1) acceptable to all parties in an economic transaction.(1)

Explain what an insurance company is. (2 marks)

A financial institution that guarantees compensation for specified losses(1) in return for regular payments known as premiums.(1)

Explain what a mortgage is. (2 marks)

A loan for the purchase of property(1) usually secured against the property it is purchasing.(1)

Explain how a building society differs from a bannk. (2 marks)

Although they offer deposit products and mortgages like a bank they do not operate to make a profit(1) but instead for the benefit of their members.(1)

Explain what monopoly power is. (2 marks)

When one firm controls 25% or more of their market(1) they acquire some of the influence normally attributed to a monopoly.(1)

Case study/Scenario

Martyn runs a building and construction firm Allwood. He does extensions on people's houses. Projects of this size can be quite expensive.

With interest rates rising Martyn is concerned about how this might affect demand for his services in the future. As he doesn't ask he can't be sure how many of the people he works for borrow money to get their extensions built but he thinks this will be an important factor in how much demand is affected for his business.

Analyse the effect on investment of an increase in interest rates. (6 marks)

Sample answer:

Investment in economics refers to spending on capital goods that can be used to produce more goods.{AO1} One way to fund investment is through borrowing. As interest rates rise the cost of borrowing to fund it rises{AO2} this means firms have to pay more so they would have to anticipate higher profits to proceed.{AO3a}

Another way to fund investment would be through retained profits.{AO2} As the interest rates rise so does the opportunity cost of using profits to invest{AO3a}. This means firms may prefer to just save the money and earn interest.{AO3a}

Evaluate the importance of the financial sector for Allwood's customers. (6 marks)

Sample answer:

Home extensions are expensive and some of the financial sector provides loans{AO2} that enable people to be able to get their extension done now and pay for it later{AO3a} and allowing them to enjoy it sooner increasing their quality of life.{AO3a}

For others they may use their savings to pay for a house extension. Financial institutions also provide savings products that offer interest to savers that might help them to afford a home extension.{AO3b} The financial sector also provides insurance which you would likely adjust to include your new home extension.{AO3b}

The financial sector is likely to be useful for all of the customers of Allwood but more important for those who need to get a loan who will probably also first have to save for a deposit and take out insurance to protect the property while they pay it off.{AO3b}

Additional notes:

This is one of those tricky evaluate ones where it doesn't make sense it is of no use to anyone but rather that there are some people for whom it is more important than others.