Introduction
Money plays a vital role in the determination of income and employment . interest rate are a significant determinant of aggregate spending ad the Federal Reserve which controls the money growth and the interest rates is the first institution to be blamed when the economy of in trouble. Now the question arises what is money.
Money Definition
Money is a medium of exchange. Money is divided into commodity money and token money. To some economist there is difference between commodity money and token money. A commodity money is a medium of exchange which has a commodity value as distinct from a value which it acquired by being generally acceptable in exchange for goods and services. In history there was a barter system where different types of commodities served as a medium of exchange like cattle, stones, grains, metals etc. But all these commodities are not equally suited to serve as money. To act as a good medium of exchange the commodity must be durable portable and easy to recognize and difficult to counterfeit. So minted coins were developed which made good money and possessed all the qualities.
Token money has no commodity value. Its value is derived from the fact that it is generally acceptable in exchange for goods and services. Paper money is token money a sit ahs no commodity value. This money may not take physical form at all. For example when a customer of a bank makes a payment by writing a cheque he simply instructs the bank to transfer the part of his claim on the bank to the payee. Since such transfers of banks deposits are generally accepted in state; lemamt of a debt we must include bank deposits in accordance with our functional definition. So cheque is not money it is simple a written order to transfer The market is divided into two types goods narket and money market.
Goods Market and Money market
There are two market in an economy goods market and money market . These two are part of asset market. The two markets are affected by interest rate and income.
Goods market is the ,market where the buying and selling of goods and services takes place in the money market.
Money market is the global financial market for short term transactions. It is the market where the demand and supply of money takes place. The demand for money of the demand for real balances which is dependent on the level of real income and interest rate. It also depends on the level of real income because individuals hold money to pay for their purchases which in turn depend on income. The higher the interest rate the more costly it is to hold money and accordingly the less cash will be held at each level of income.
The supply of money is the total stock of currency or other liquid instruments of a country in a particular period of time. The central bank controls the supply of money in the market. In United States the Federal Reserve controls the money supply. The money supply is composed of the currency held with the public and the demand deposits with the public.
Financial Market
The money market is a major component of financial market ( a market that brings buyers and sellers together for trading in stocks, bond, commodities, derivatives and currencies)that is sued for short term basis like certificates of deposits(CDs), bankers acceptances, U.S treasury Bills, commercial paper, municipal notes, eurodollars, federal funds whereas another component of financial market – capital market deals with long term assets. Capital market deals with equity market and debt or bond market. This market raises money through the sale of securities of stocks and bonds in the company's name that are bought and sold. Both money market and capital market manage liquidity and risks for companies, governments and individuals. Other than these two main components of financial market there are derivatives market, Forex and interbank market, primary mad secondary market and over the counter market(OTC).
.
Different Financial Institutions
All the transactions of the financial market are controlled by the financial institutions like investments, loans, deposits, exchanging currencies.
The primary and main financial institution that we deal in daily transaction are the commercial banks. These banks provide security and easy methods of depositing and taking loan for the customers. It is risky to keep the money earned at home or in the wallet but with banks there is no such risk of losing money due to theft or other incidents. These banks provide loans to the customer and businesses to purchase goods and services and also expand the businesses. The banks lend money at high interest rate which the customers have to pay to enjoy the benefits.
During the Great Depression the market crashed in the year 1929 an U.S decided to increase the regulation of the financial market .So a type of financial market came up as investment banking which is different from commercial banking. It mainly deals with underwriting of debt and equity offering, act as an intermediary between the companies issuing the securities and investing in public. It also acts like a broker for institutional clients. It also plays the role of financial advisor to several companies and focus on initial public offerings(IPO). The top investment banks are JP Morgan Chase, Bank of America and Citigroup, Goldman Sachs, Lehman brothers and First Boston.
Then there are Insurance companies which operate be collecting premiums from people. They provide the protection to the families paying premium through fire, car accident, death , disability etc. They make profit by increasing the number of people interested in taking a particular insurance and paying the premium. They also settle the claims.
The Brokerage is also a financial institution that acts as an intermediary between buyer of stocks and sellers. The earn profit through commission after the transaction has been successfully completed.
Then there are the investment companies which are corporation or trust where the individuals invest in diversified stocks and bonds that are managed by professional by investing in the right stocks or bonds so that the customer can get good returns.
Stocks and Indexes
The institutions are beneficial only when there is liquidity in the market. Stocks and bonds for the backbone of any economy. Without this market the businesses and investors are derived of the liquid cash. Stocks are important in dealings of buying and selling in the equity market but bonds are not that happening. But bonds are also very important in the growth of a company ant the country. To measure the percentage of increase and decrease in a particular stocks there are various indexes. The market index is the total value produced by several stocks or other investments and expressing their values against a base value from a specific date. It represents the entire stock market and track the changes happening in different time periods.
There are different indexes in different countries. One of the oldest and renowned index in the Dow-Jones Industrial Average(DJIA). This U.S index include 30 largest industrial companies. Then there is Standard & Poor 500 Index which is larger and more diverse than Dow-Jones Index. It consist of 500 companies which are frequently traded and represents value of 70% of the total stock value of U.S stock market.
The Nasdaq Index is the index where mostly the technology stock are traded. It also includes companies outside of U.S. Though this index mainly includes technology stocks but other stocks from financial sector, insurance , transportation and others.
Global Financial Crisis of 2007
The global financial crisis of the year 2007-08 started with the subprime mortgage crisis. The rise in the home prices created the housing bubble in 2004. The lenders engaged a lot of risky people into "subprime-lending". They easily got a loan with low interest rates for a few years .Then the interest rates were raised by the federal reserve suddenly. In this period many organizations made huge amount of money like construction business, realtors, banks etc. But the rise interest rates created the crisis. Many risky borrowers were bankrupt and the financial sectors faced huge losses. This downfall of the prices affected the U.S financial sector. The first major institution Countrywide Financial Corp one of the largest mortgage lender in U.S was totally bankrupt as the subprime lenders were failing to pay the money . The stock prices stated declining after reaching high in the end of the year 2007. The selling of stocks increased when the news of the bankruptcy of the Lehman brothers came into news in September 2008. During this time the U.S house of representatives failed to pass the Treasury bail out and the S& P 500 fell by 8.8%. On September 29 this was the biggest percentage fall and is known as Black Monday. Due to this fall the U.s stock market lost $ 1 trillion in a single day and the investors faced huge losses. The loss of some investors was so huge that were left with no substantial amount of money. As the U.S stock market declined there was a reaction to other global markets of Europe, Asia countries like Britain, Russia, Mexico where the losses were huge.
On the part of the investors , the confidence level and trust on the stock market crashed. This confidence increase the buying of stocks and losing the confidence results in selling of stocks. One of the indicator of the level of market confidence is given by the London Interbank Offered rate(LIBOR). It is the rate at which the global banks are willing to lend each other on a short term basis.. It tracks the movements of short term U.S treasury Securities. This indicator remain unchanged during the period of credit crisis but suddenly showed a spark after the fall of the Lehman brothers. It indicated that bank are not willing to lend money to one another. This was sign of trouble in the financial market and was a matter of concern among the policymakers that the global financial system will collapse. But in October 2008 the LIBOR fell which gave a relief to the financial policy makers that the market is becoming stable.
The economic impact of the Crisis
The global meltdown caused the economy to suffer from accredit crunch. Before the crisis the non banking financial firms had huge amount of cash. The net debt ration which was negative in 2004 became more negative in the year 2007. A British investor Jeremy Grantham explained the global meltdown as "responsible for financial crisis' in the Efficient Market Hypothesis(EMH). It is one of the most controversial topics in economics. It is defined as theory in which the asset prices reflect all publically information about the asset value. The relation between this hypothesis and the financial crisis is that the crisis cannot be predicted accurately. Since prices do not have according to us and are random in nature so the change in the asset prices cannot be made using the previous information. So the crisis of 2007 should have occurred in an efficient market with other unpredictable causes.
The low interest rate by the federal reserve provided incentive for the investors to take risk and put their money into a long term , high yielding securities such as the housing market. So the banks and the credit rating companies are to be blamed as they invested into the subprime mortgage market which caused the market to crash. So the EMH cannot be blamed as the root cause of the financial crisis of 2007.
Works Cited
Ray, Ball. “The Global Financial Crisis and the Efficient Market Hypothesis: What Have We Learned?” University of Chicago Volume 21 (2009)
www.faculty.chicagobooth.edu/john.cochrane/teaching/35150_advanced_investment/
Keating, Dave. "The 2008 economic crisis explained". Cafebabel.(2008) 7th October
www.cafebabel.co.uk/politics/article/the-2008-economic-crisis-explained.html
