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Topic 2.8
The Role of Money and Financial Markets
In this topic, you will learn about how money acts as a medium of exchange. You will also find out about the different types of financial institutions, including banks, insurance companies, and building societies. By the end of the topic you should be able to explain the differences between the roles of commercial and central banks. This is the final topic in paper 1!
The Role of Money as a Medium of Exchange
Money is anything that is generally accepted as a means of payment for goods and services, consisting of legal tender (notes/coins) and bank deposits (current/savings accounts). Cheques, credit and debit cards are not money, but they transfer money.
A medium of exchange is anything that sets the standard of value of goods and services acceptable to all parties involved in a transaction. Money acts as a medium of exchange as it is valuable to both the buyer and the seller
The role of Financial Sectors
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The financial sector consists of financial organisations and their products, and involves the flow of capital. It helps a market to function and helps the three economic groups carry out their function.
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Investment is the purchase of capital goods that are used to produce future goods/services. It is also an asset purchased to provide an income in the future and/or to be sold for profit.
Credit vs Debit cards
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Debit Cards take money directly from your current account and transfer it to the seller - you can't buy the product if there isn't enough money in the account. There is no charge to the seller for accepting these cards for payment.
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Credit cards enable you to buy goods whether or not you have the money in your account, but you need to pay the money back after each month - it is essentially a 30 day loan - if you don't pay it back you are charged interest. Retailers are charged for allowing you to use these cards for payment.
Types of financial institutions
Banks
There are two main types of banks. The first is a central bank which is the main bank of a country that controls the economy. The other is commercial banks such as HBSC that make profit by offering a service to consumers. Scroll down for more detail.
Building societies
Mortgage/building societies are not companies but mutual financial institutions that are owned by its members. Its primary objectives are to receive deposits from members and to lend money to them to buy property. Examples include Nationwide and Halifax that started out as a building society.
Insurance Companies
Insurance companies guarantee compensation for a specifies loss, damage, illness or death, in return for an agreed premium (payment) that the consumer pays. Scroll down for more detail. They offer two types of insurance: life insurance and general insurance
Types of Insurance
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Life insurance - This aims to pay out money to the surviving family if the insured person dies, in order to replace the loss of income due to the death of the insured person.
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General Insurance - This covers all 'non-life' policies and includes property, for example. It helps a person deal with an unexpected event e.g. car crash/ burglary/house burning down
Commercial vs Central Banks
Role of Central Banks
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To issue bank notes
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Supervise the supply of money in an economy
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Control monetary policy (through the bank rate, and quantitative easing)
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Maintaining financial stability
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Managing a country's foreign reserves and intervene in the foreign exchange market
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Act as the bank for commercial banks and the government
Role of Commercial Banks
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Banks accept deposits, keep the saving safe and pay interest on them
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They make payments on behalf of customers (card payment)
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They issue loans and overdraft facilities which are paid back with interest
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They offer safe deposit boxes for very expensive items such as jewellery
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They take savings from customers and turn them into assets through investment
How do banks decide the interest rates?
The interest rate is the reward for saving and the cost for borrowing
Interest rates are determined by a combination of the central bank's base rate and the commercial banks' own cost of funds. Banks choose their interest rate based off the Bank Rate set by the Bank of England. Commercial banks set their lending rates slightly higher than the base rate to earn a profit margin (the spread), while keeping savings rates competitive enough to attract deposits. The specific rate offered to a customer often depends on their credit risk profile and the duration of the loan or deposit.
Evaluating the importance of the financial sector to consumers
Points
Evaluations
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Credit Provision - The financial sector, mainly commercial banks, provides credit to consumers, allowing them to borrow. This means that they can afford big purchases which they wouldn’t have been able to afford previously. This means that they can live beyond their means. This means that they can, if in dire need for it, take out credit to help during emergencies, or keep spending on needs (e.g. food) stable if income fluctuates. This is economically sustainable for the consumers and benefits them.
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Liquidity Provision - Banks have the ability to provide liquidity to producers too. This means that they can turn assets quickly into cash. This means that they can access cash quickly, especially in case of emergency. This means that they have more financial flexibility.
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Risk Management - The financial sector allows consumers to pool their risks from exposure to financial markets. This means that they have less risk of losing a lot of money if something goes wrong. This means that they can diversify. For example, commercial banks can invest their money into multiple different shares, so that even if one’s share price decreases, they will still have others.
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Insurance - Another role of the financial sector is to provide insurance. This means that if a specified loss occurs, such as death or a motor crash, the consumer can get a premium. This means that they get guaranteed compensation during an unfortunate event.
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Cycle of Borrowing - The financial sector also charges interest when money is being borrowed. This means that the consumers must pay the entire sum, plus a small percentage of that sum extra. This leads to a vicious cycle of debt in the long run if it isn’t paid back, which can lead to fiscal stress, overconsumption, and legal problems. This cycle of borrowing means that consumers’ credit score can decrease, and it can be very unsustainable economically.
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Overreliance - However, consumers can become overreliant on liquidity, especially through easy access to credit such as overdrafts, credit cards, and buy-now-pay-later schemes. This constant availability of funds can encourage impulsive spending and poor budgeting habits. Over time, this dependence can reduce financial resilience, leaving consumers vulnerable in emergencies or economic downturns.
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Not fully understanding - Some consumers don’t know fully how to manage risk. This means that investing in stocks without proper knowledge can actually increase risk, especially if consumers follow trends or make emotional decisions.Also, not all financial advice is unbiased — some institutions may promote products that benefit them more than the consumer.
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Consumers often struggle to make successful claims as insurance companies do a lot of digging into the matter, so they normally get a reduced compensation. This can be damaging as insurance companies always ask for high premiums. Sometimes the insurance money isn’t even claimed so there is money being paid regularly for no purpose (on premiums) - opportunity costs
Evaluating the importance of the financial sector to producers
Points
Evaluations
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Credit Provision - The financial sector, mainly commercial banks, provide loans for producers when they lack internal funds, this in turn leads to producers investing in capital (machinery) which helps increase productivity, leading to higher output.
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Managing risk - Financial institutions such as insurance companies provide insurance to businesses. This allows them to manage risks such as fire or theft.
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Liquidity provision - Allows firms to have a stable cash flow, because they can quickly convert their assets into cash, this is helpful for short-term funding, when firms need to pay money for wages or suppliers.
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Inflation rates - In a booming economy, there would be high inflation rates (AD curve shifting right) therefore there would be higher interest rates as the central bank would be employing contractionary monetary policy to try and decrease borrowing. Therefore there would be a higher cost of borrowing loans, meaning businesses would be unwilling or unable to take loans from commercial banks due to high interest rates.
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Insurance costs - The costs of the producers increase if they want insurance, which harms smaller firms who want to make a profit if they have just entered the market.
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Overreliance - Liquidity may become costly if it is overused by producers
Evaluating the importance of the financial sector to the government
Points
Evaluations
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Credit Provision - Credit provision leads to increased consumption as people can use the overdraft facility to purchase goods even if they do not have the money right away. Increased consumption will lead to increased demand for products, so there will be increased labour demand for workers, leading to an increase in employment.
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Liquidity Provision - Allows businesses to function as assets can be turned into cash when it is required, which will increase production in the economy so there will be a rise in standard of living as more G/S are available and increased employment to produce more
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Increased investment - Government can borrow money using treasury bonds using the financial sector, which allows it to provide more subsidies to producers, which gives them more resources to invest in the factors of production, increasing production. G/S.
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Borrowing can reduce government debt
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Unsustainability - Repeated use of the credit provision by consumers can be unsustainable economically, as if the overdraft facility is left unpaid, then the consumer must pay interest on top of the overdraft payment, causing them to lose money as a result. This is economically unsustainable as it loses resources in the future, and could lead to a decrease in consumption in the future.
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Overreliance - Increased liquidity will lead to producers becoming overeliant and investing too heavily, so they will have fewer funds in a recession and will struggle, leading to decreased production
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Government debt - If the government borrows too much money, there may not be sufficient return on the government’s investment, meaning they will struggle to pay back the treasury bonds with interest, leading the government to go into debt. Budget deficit - intergenerational inequality
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Key Tip: All three 6-markers can be answered using the same points (credit provision, insurance, liquidity provision and risk management), so make sure you memorise these four points (and their evaluations) - you can easily adapt them to each economic group.