Financial System, Assets, and Monetary Policy

Posted on Feb 15, 2025 in Economy

The Financial System and Monetary Policy

1. The Financial System and Its Intermediaries

The financial system comprises financial intermediaries and the markets in which they operate. Its function is to connect and coordinate to provide funding to meet demand.

Financial intermediaries include:

  • Private banks aimed at making profits for their owners.
  • Savings banks are nonprofit entities that allocate their profits to charitable and social causes.
  • Credit unions whose depositors are their partners, who are, in turn, the beneficiaries of their financial services.

2. What Are Financial Assets?

Financial assets are securities that constitute recognition of a debt by the issuer and give the holder the right to their collection. Examples include public debt securities like Treasury bills, bonds, and state obligations.

Characteristics of Financial Assets

  • Return: The return investors get from an asset.
  • Fixed Income: Performance known a priori.
  • Equity: Performance depends on the company’s performance.
  • Risk: Depends on the repayment period and guarantees the issuer provides to meet debt obligations when due.
  • Liquidity: The degree of ease with which an asset can be converted into cash without significant costs.

The Issuance of Bonds and Shares

When companies need significant amounts of money, they have two primary financing methods: issuing shares and issuing bonds.

  1. Issuance of shares: Shares are equities.
  2. Debentures: Bonds are fixed-income securities. The shareholder owns a part of the company, while the bondholder is a creditor.

If the firm is profitable, shareholders share in these benefits, while bondholders receive the agreed interest. If the company experiences difficulties, bondholders get their interest, but shareholders may receive nothing. Shares have more risk but potentially higher returns.

3. The Stock Market

The stock market is a niche market for selling all types of titles; its function is to channel savings into investment.

  • Primary Markets: Selling titles for the first time; assets are newly created.
  • Secondary Markets: Existing securities are traded.

4. Stock Indices

Stock indices reflect the evolution over time of the prices of traded securities.

5. Real Interest Rates and Nominal Interest Rates

  • Nominal Interest Rate: The yield offered to us by our savings or borrowing.
  • Real Interest Rate: The nominal interest rate adjusted to account for inflation: Real interest rate = Nominal interest rate – Inflation rate.

6. Monetary Policy

Monetary policy consists of decisions that the monetary authority takes regarding the interest rate and money supply to facilitate economic growth, employment, and price stability.

Monetary Policy Rates

  1. Expansionary Monetary Policy: Aims to promote economic growth and job creation. The ECB pays more money in the weekly auctions or lowers the interest rate.
  2. Restrictive Monetary Policy: The ECB pays less money to banks, interest rates rise or raises the reserve requirement.

Vocabulary

Value: The amount by which an action is issued, an obligation, and other commercial documents.