What are the money and foreign exchange markets? What forces influence
supply and demand in these markets?
The Money and Foreign Exchange Markets Are Key Components of the Financial System
Money markets are the financial markets where short-term financial assets
are bought and sold. By definition, the financial assets, such as stocks
and bonds, that are traded in these markets will mature in one year or
less. Over a billion dollars in transactions take place in these markets
on a daily basis. Financial institutions, corporations, governments, and
the U.S. Treasury are active in the money markets as they adjust their
Foreign exchange markets facilitate the trade of one foreign currency
for another. Most exchanges are made in bank deposits and involve U.S.
dollars. Over a trillion dollars in foreign exchange trades take place
every day; foreign exchange dealers handle most transactions. Businesses,
financial institutions, governments, investors, and individuals use the
foreign exchange markets to adjust their currency holdings.
Domestic Money Markets
Money markets provide an important mechanism in an economy for transferring
short-term funds from lenders to borrowers.
For corporations, governments, and financial institutions with temporary
excess funds, these markets provide an efficient means to lend to other
corporations, governments, and individuals who have a temporary need for
funds. Money markets, therefore, represent the short-term spectrum of
the financial markets, where securities that mature in a year or less
Key money market characteristics:
- "Generally characterized by a high degree of safety of principal."
- Most markets are informal "telephone" markets with low transaction
- Assets are typically issued in large denominations, often $1 million
- Most money market instruments are liquid, which means that they can
be quickly converted into cash assets without a sizeable loss.
Each day billions of dollars are traded in the money markets. Several
important money market instruments are listed below:
- U.S. Treasury bills
- Short-term Federal agency securities
- Commercial paper
- Federal funds
- Net Eurodollar borrowings by domestic banks from their own foreign branches
- Large-denomination certificates of deposit ($100,000 or more)
Money Market Interest Rates
Forces influencing interest rates in the money markets are varied and
may reflect supply and demand conditions in different money market instruments.
There are also broader forces that affect interest rates in all money
and capital markets. Rose notes that Treasury bills, with no default risk
and an active secondary market, usually yield the lowest rate in the money
market and that other instruments appear to move with Treasury bill rates.
Goodfriend and Whelpley, however, point out that the current and expected
interest rates on federal funds are "
the basic rates to which
all other money market rates are anchored." That relationship reflects
the use of the federal funds rate by the Federal Reserve in implementing
Foreign Exchange Markets Play an Important Role
The foreign exchange markets play a critical role in facilitating cross-border
trade, investment, and financial transactions. These markets allow firms
making transactions in foreign currencies to convert the currencies or
deposits they have into the currencies or deposits they want. Most transactions
are handled by foreign exchange dealers; on a typical day they handle
over a trillion dollars in foreign currency exchanges involving U.S. dollars
alone. The importance of foreign exchange markets has grown with increased
global economic activity, trade, and investment, and with technology that
makes real-time exchange of information and trading possible.
Factors Driving Exchange Rate Movements
A number of factors may influence foreign exchange rates, including the
following cited by Rose (1994):
- Balance-of-payments position. A country experiencing a trade deficit
usually faces downward pressure on its foreign exchange rate.
- Speculation over future currency values. Speculators buy or sell currencies
when they see profitable opportunities.
- Domestic economic and political conditions. Deteriorating economic
conditions and inflation typically have an adverse affect on foreign
- Central bank intervention. Central banks may buy or sell currencies
to influence the value of their currency.
Cook, Timothy Q., and Robert K. LaRoche, editors.
(1993) Instruments of the Money Market, Federal Reserve Bank of
Richmond, Richmond, Virginia.
Federal Reserve Bank of New York. All About
Foreign Exchange Market in the United States, July 23, 2001.
Rose, Peter S. Money and Capital Markets,
Irwin, Burr Ridge, Illinois, Fifth Edition, 1994.
See other Dr. Econ Answers:
What makes Treasury bill rates rise and fall?
What effect does the economy have on T-bill rates? December 2000.
Why does a trade deficit weaken the currency?