Functions of the Money Market

Money markets are large and liquid markets. They exist in almost every country which has a developed financial system. The existence of a thriving and highly liquid money market in every economy of the world is not a mere coincidence.

There are certain functions that are performed by the money market.

Some of these functions have been listed and explained in detail in this article.

1. Short Term Funds for Banks and Private Entities

   The money market performs a crucial function for all banks and private entities. Banks are required to maintain reserves to cover the loans that they make. However, the process of accepting deposits and issuing loans happens simultaneously. Hence, banks do not have the exact amount of reserves required.

   Some banks end up having more reserves than required whereas others end up with fewer reserves than required. The interbank market which is a component of the money market allows banks with excess funds to lend money to banks with deficient funds overnight.

   Hence, even though individual banks may have less or more reserves, the industry as a whole has the required reserves. The existence of an interbank market allows banks to conduct their deposit-taking as well as lending activity without fear of being unable to meet the reserve requirements. Hence, the money market enables the banking system to function at an optimal level.

   This is also the case for other private entities. The money market allows for entities with excess cash to make short-term loans to entities that have deficient cash holdings. The end result is beneficial to both parties as it helps them meet their financial needs respectively.

2. Short Term Funds for Governments

   The money market enables the government to borrow short-term funds. It may seem irrelevant since the government can create more money if required. However, economists are of the opinion that since the creation of money by the government leads to inflation, the government must only use it for long-term purposes.

   When it comes to short-term loans, the government simply borrows money from the money market by issuing treasury bills. These do not have an inflationary effect on the overall economy.

3. Helps In Implementing Monetary Policy Implementation

   The money market can be used as a barometer to gauge the success of the monetary policy. In order to control the interest rates, governments create monetary policies which specifically target the interbank rate. Since the interbank rate is a benchmark rate, controlling that rate provides a high degree of control over the interest rates in the entire economy.

   It also needs to be understood that the central bank has a great deal of influence on commercial banks. Also, these commercial banks are huge players in the various sectors of the monetary market. Hence, the central bank can use the influence of the commercial banks to influence the operations of the money market in such a manner that it aligns with the overall objective of the monetary policy.

4. Promotes Liquidity

   In the absence of a highly liquid and short-term money market, entities across the world would be forced to hoard a large amount of cash for their transactional purposes. This would lead to lesser productivity as the smooth flow of funds would not be possible.

   

   Money markets provide the much-needed liquidity to the market. They allow entities to hold their funds in cash equivalent assets instead of cash. This means that the funds are not lying idle but instead can be used by other entities.

5. Promotes Utilization of Funds Across Sectors

   The money market also performs the function that all financial markets must perform i.e. it must channelize funds towards the most profitable investments.

   There are various types of government and private entities which participate in the money market. Hence, if a particular sector of the economy is more profitable, it is able to obtain funds from the other sectors.

   For instance, the flow of funds could be from the banking sector to the industrial sector in the money market. This helps firms diversify their own risks while also allowing the most efficient sector to have access to large amounts of funds.

6. Financing International Trade

   The money markets play an important role in financing international trade as well. This is because a large number of private entities utilize money markets to raise short-term funds. These short-term funds are often used as working capital for international trade-related activities.

   For instance, a company may borrow funds from the money market in order to open a letter of credit at a bank. Many suppliers do not release the shipment of goods until the funds have been deposited into the bank issuing the letter of credit.

The fact of the matter is that money markets are very important for the overall economy. They play a pivotal role in the day-to-day functioning of the economy and are crucial when it comes to the implementation of monetary policy. It is therefore impossible for the central banks to have a reasonable amount of control over the monetary policy unless they have strong and efficient money markets in place which help in implementing the policy at the grassroots level.