Block 2. The Study of Money and Capital Markets

*The money and capital markets are the mechanism for converting the public's savings into investments in buildings, machinery and equipment, public facilities, and inventories of goods and services that make it possible for the economy to grow, for new jobs to be created, and for living standards to rise. *It is the financial system that handles most of the payments made for purchases of food, clothing, shelter, automobiles, and tens of thousands of other goods and services. That system also generates credit to sustain the public's spending and standard of living and stores future purchasing power in the form of stocks, bonds, and other securities. And the money and capital markets make possible the liquidation of those securities whenever cash is needed for immediate spending.

The financial system offers risk protection to businesses and individuals through sales of insurance policies and hedging instruments such as options, futures, and swaps. And both domestic and international financial systems today carry the great burden of public policy, serving as the conduit for government actions designed to promote economic growth, a stable international economy, low unemployment, and stable prices of goods and services.

A. The Money Market versus the Capital Market

The flow of funds through the financial markets may be divided into different segments, depending upon the characteristics of financial claims being traded and the needs of different groups. One of the most important divisions in the financial system is between the money market and the capital market.

The money market is designed for the making of short-term loans. It is the institution through which individuals and institutions with temporary surpluses of funds meet borrowers who have temporary funds shortages.

Thus, the money market enables economic units (principally business firms and governments) to manage liquidity. By convention, a security or loan maturing within one year or less is considered to be a money market instrument. *One of the principal functions of the money market is to finance the working-capital needs of corporations and to provide governments with short-term funds in lieu of tax collections. The money market also supplies funds for speculative buying of securities and commodities.

*In contrast, the capital market is designed to finance long-term investments by businesses, governments, and households. Trading of funds in the capital market makes possible the construction of factories, highways, schools, and homes. Financial instruments in the capital market have original maturities of more than one year and range in size from small loan to very large, multimillion dollar credits.

Who are the principal suppliers and demanders of funds in the money market and capital market? In the money market commercial banks and the most important institutional supplier of funds (lender) to both business firms and governments. Nonfinancial business corporations with temporary cash surpluses also provide substantial short-term funds to banks, securities dealers, and other corporations in the money market. On the demand for funds side the largest borrower in the American money market is the U.S. Treasury, which borrows several billion dollars weekly. *The largest and best known corporations and securities dealers are also active borrowers in the money market through their offerings of short-term notes. *Finally, there is the Federal Reserve System, which is charged by Congress with responsobility for regulating the flow of money and credit in the U.S. financial system and keeping the money market functioning smoothly. Due to the large size and strong financial standing of these well-known money market borrowers and lenders, money market instruments are considered to be high-quality "near money" IOUs

The principal suppliers and demanders of funds in the capital markets are more varied than in the money market. Families and individuals, for example, tap the capital market when they borrow to finance a new home State and local governments rely upon the capital market for funds to build schools and highways and provide essential services to the public. The U.S. Treasury draws upon the capital market in issuing long-term notes and bonds to pay for federal government programs. The most important borrowers in the capital market are businesses of all sizes, which issue long-term IOUs to cover the purchase of equipment and the construction of new plant and other facilities. Ranged against these many borrowers in the capital market are financial institutions, such as banks, insurance companies, and pension funds, that supply the bulk of long-term funds.