Dr. Econ

What are the money and foreign exchange markets? What forces influence supply and demand in these markets?

June 2001

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 short-term portfolios.

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.1 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 are traded.

Key money market characteristics:2

  • "Generally characterized by a high degree of safety of principal."
  • Most markets are informal "telephone" markets with low transaction costs.
  • Assets are typically issued in large denominations, often $1 million or more.
  • 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:3

  • 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 monetary policy.4

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 exchange rates.
  • Central bank intervention. Central banks may buy or sell currencies to influence the value of their currency.

Endnotes

1. See Cook (1993), editor, Instruments of the Money Market, Federal Reserve Bank of Richmond, page 1.

2. Cook, page 1

3. Other money market instruments include bankers’ acceptances, and securities repurchase agreements. In addition, futures, options, and swaps markets usually involve money market instruments.

4. See Cook (1993), Chapter 2, page 7, Goodfriend, Marvin, and William Whelpley, "Federal Funds."

References

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…the Foreign Exchange Market in the United States, July 23, 2001.
http://www.ny.frb.org/pihome/

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.
/education/activities/drecon/2000/0012.html

Why does a trade deficit weaken the currency? October 1999.
/education/activities/drecon/1999/9910.html