Functions of Money Market with Examples

Functions of Money Market with Examples

8 mins read3.8K Views Comment
Chanchal
Chanchal Aggarwal
Senior Executive Content
Updated on Feb 8, 2024 15:11 IST

The money market serves as a hub for short-term borrowing, lending, and trading of financial instruments. Functions of money market include price discovery, liquidity management, trade financing, risk mitigation, supports government funding needs, and central bank operations.

2023_08_Functions-of-Money-Market.jpg

The money market is a vital part of the financial world that deals with short-term borrowing, lending, and trading of financial instruments. Think of it as a marketplace where businesses, banks, governments, and investors meet to manage their money in the short run – usually a year or less. Just like people use savings accounts for quick access to their funds, these players use the money market to meet their immediate cash needs or to invest their extra money safely for short periods. It’s like a hub that helps keep the financial gears running smoothly, ensuring everyone has the money they need when they need it. Let’s understand the functions of the Money Market.

Check out: What is Finance?

Table of Content

Explore Investing Courses

What is Money Market?

The money market refers to a financial market segment where short-term borrowing, lending, buying, and selling of financial instruments occur. These instruments typically have one year or less maturities. It makes them suitable for managing immediate liquidity needs and short-term financial obligations. The money market provides a platform for various entities, such as governments, corporations, banks, and investors. This is done to engage in transactions that help them meet their short-term funding requirements or invest their surplus funds. 

Examples of money market instruments include Treasury bills, commercial paper, certificates of deposit, banker’s acceptances, and repurchase agreements. The money market’s efficiency and liquidity stabilise the financial system and support economic activities by facilitating smooth capital flow and short-term financing solutions.

Difference Between Money Market and Capital Market
Difference Between Money Market and Capital Market
The money market is a part of financial markets where instruments with high liquidity and short-term maturities are traded. Short-term securities with a maturity period of one year or less...read more
What is Primary Market: Types and Key Players
What is Primary Market: Types and Key Players
The primary market, or the “new issue market,” is a financial marketplace where companies issue new securities to the public for the first time to raise capital. Investors who purchase...read more

Functions of Money Market

The money market serves as a platform for short-term borrowing and lending of funds, facilitating liquidity management and ensuring efficient capital allocation in the financial system. The important functions of the money market include short-term borrowing and lending, price discovery, liquidity management, financing trade and commerce, reserve management for banks, etc. Let’s understand them in detail.

Capital Markets: Understanding the Basics and Importance
Capital Markets: Understanding the Basics and Importance
Capital markets are essential components of the financial system that facilitate the buying and selling of various financial instruments, primarily to raise capital. This article provides an overview of capital...read more

What is Secondary Market: Types and Functions
What is Secondary Market: Types and Functions
A secondary market is a financial market where previously issued financial instruments are traded. Unlike the primary market, the original issuers of the securities do not participate in the transactions...read more

Short-Term Borrowing and Lending

The money market is a platform for institutions to meet their short-term funding needs. Banks, corporations, and governments borrow money for a brief period, usually less than a year. This bridges gaps in their cash flows or fund’s immediate requirements. On the other hand, lenders provide these funds in exchange for interest income. It allows them to earn a return on their surplus funds.

Example: Imagine a startup needing ₹500,000 for a new product launch. They borrow from a bank with a promise to repay the amount plus interest in six months. Conversely, the bank lends some excess funds to the startup, earning interest on the loan.

Price Discovery

It is the next function of the money market where the instruments, such as treasury bills and commercial paper, are actively traded. The prices of these instruments reflect prevailing market interest rates. This price discovery mechanism aids in determining the cost of short-term borrowing and the potential returns for lenders. As a result, the money market plays a crucial role in assessing the overall health of the financial system and the broader economy.

Example: Suppose the government issues Treasury bills with different face values. The market prices of these bills during their sale reveal prevailing interest rates. Higher prices indicate lower rates, reflecting economic conditions and investor expectations.

Features of Money Markets
Features of Money Markets
The money market is the set of markets where different financial assets that occur in the short term are exchanged. These markets meet the need for short-term borrowing and borrowing...read more

Investment Management: Services, Advantages and Disadvantages
Investment Management: Services, Advantages and Disadvantages
Investment management is a process of managing and increasing your funds for your future financial requirements. This is achieved through several investing services such as tax and retirement planning.

Liquidity Management

Investors seeking secure and easily accessible avenues for excess funds turn to the money market. Money market instruments are highly liquid, meaning they can be quickly converted into cash without significant loss in value. This liquidity feature ensures that investors can swiftly access their funds in need. It makes the money market a reliable option for managing short-term liquidity requirements. 

Example: An individual invests ₹5,000 in a money market mutual fund. Later, they face an unexpected medical expense and need ₹3,000 urgently. They redeem their fund shares, quickly accessing the needed funds due to the high liquidity of the investment.

Financing Trade and Commerce

In this money market function, international trade is supported by providing financing solutions for exporters and importers. Instruments like letters of credit and banker’s acceptances facilitate cross-border transactions. Importers can use these instruments to assure payment to exporters, while exporters can obtain funds before goods are delivered. This function promotes smoother trade activities and reduces the risk of international transactions.

Example: A company in the United States wants to buy machinery from a manufacturer in Germany. The U.S. company obtains a banker’s acceptance to assure the German company of payment. This instrument guarantees the payment will be made when the machinery arrives, promoting trust in cross-border trade.

Difference between Trade and Commerce
Difference between Trade and Commerce
Understanding the disparity between trade and commerce is essential for business success. While trade focuses on the exchange of goods, commerce encompasses a broader spectrum, encompassing trade, services, and various...read more

Difference Between Bank Rate and Repo Rate
Difference Between Bank Rate and Repo Rate
The primary difference between Bank Rate and Repo Rate lies in their purpose and duration. Bank Rate is used for longer-term lending and has a broader impact on the economy,...read more

Reserve Management for Banks

Banks must maintain certain reserves to ensure their stability and compliance with regulations. The money market allows them to earn interest on these idle funds. Banks can optimise their reserves by investing in money market instruments and generate a modest return while fulfilling their regulatory obligations.

Example: A bank holds $10 million in reserves to meet regulatory requirements. Instead of keeping these funds idle, the bank invests a portion in short-term instruments like Treasury bills. This way, the bank earns interest on the reserves, optimizing their use.

Yield Enhancement

Investors seeking conservative yet yielding investment options find money market instruments attractive. These instruments provide moderate returns compared to traditional savings accounts or certificates of deposit. It makes them a preferred choice for individuals and organizations looking to enhance their yields without taking excessive risk.

Example: An individual seeking better returns than a standard savings account invests $2,000 in a money market fund. This fund invests in various money market instruments. It offers a slightly higher yield with relatively low risk than a traditional savings account.

Central Bank Operations

Central banks utilize the money market to implement monetary policy measures. They buy or sell money market instruments through open market operations to influence the money supply and interest rates. By adjusting these key factors, central banks aim to achieve economic goals such as controlling inflation, stimulating economic growth, or maintaining price stability.

Example: A central bank reduces the money supply to control rising inflation. It sells Treasury securities to commercial banks in exchange for cash. This reduces the available funds in the market, leading to increased interest rates and decreased spending.

Risk Mitigation

Corporations and financial institutions manage their interest rate and liquidity risks through the money market. Derivatives and short-term financing options, such as repurchase agreements (repos), enable them to hedge against adverse market movements. These risk management tools enhance financial stability and enable businesses to navigate uncertain market conditions more effectively.

Example: A corporation faces uncertainty due to fluctuating interest rates, which could impact its borrowing costs. The company enters an interest rate swap in the money market to manage this risk. This agreement helps the company exchange its fixed-rate interest payments for variable-rate payments, mitigating potential losses.

Difference Between Central Bank and Commercial Bank
Difference Between Central Bank and Commercial Bank
Commercial and central banks are essential parts of the country’s economy. While commercial banks deal directly with the end users, central banks offer their products and services to the government...read more

What is the Difference Between Bonds and Debentures?
What is the Difference Between Bonds and Debentures?
A bond is a type of security under which the debtor or issuer owes the holder debt. The debtor is obliged to offer cash flow to the creditor at the...read more

Support for Government Financing

Governments raise funds for short-term budgetary needs by issuing Treasury bills in the money market. These bills serve as a means for governments to cover temporary deficits, manage cash flow fluctuations, and meet immediate financial obligations. The money market provides a reliable source of funds for governments while offering investors a secure investment option.

Example: A government needs funds for immediate expenses during a budget shortfall. It issues Treasury bills with a promise to repay the amount after a short period, securing necessary funds quickly and efficiently.

Investor Diversification

The money market broadens investment opportunities for individuals and institutional investors. Investors can diversify their portfolios beyond traditional stocks and bonds by participating in money market activities. This diversification aids in reducing overall portfolio risk and provides a balanced investment approach that aligns with varying risk tolerances and financial goals.

Example: An investor aiming to reduce risk diversifies their portfolio. They allocate funds to different investments, including money market funds. If stock markets become volatile, the stability and liquidity of money market funds offer a secure anchor in their investment mix.

Budgetary Control: Meaning, Objectives, and Advantages
Budgetary Control: Meaning, Objectives, and Advantages
Budgetary control is a systematic process that helps organizations monitor and manage their financial performance by comparing actual results with planned budgets. It allows businesses to track expenses, identify variances,...read more

Your Guide to Portfolio Management
Your Guide to Portfolio Management
Investing can be daunting, especially for beginners. With so many options and potential risks, it's natural to feel unsure about how to proceed. This is where portfolio management comes in,...read more

Conclusion!!

The money market plays a crucial role in the financial ecosystem by facilitating short-term borrowing, lending, and investing. Its instruments provide flexibility, liquidity, and a benchmark for interest rates. From governments funding urgent needs to businesses managing day-to-day operations, the money market bridges immediate financial requirements and available funds. This dynamic marketplace ensures economic stability, efficient cash flow, and investor opportunities. This is done to serve and grow their funds while supporting the overall functioning of the financial system.

FAQs

What is the money market?

The money market is a segment of the financial market where short-term financial instruments are traded. It primarily deals with borrowing and lending for short periods, typically ranging from one day to one year.

What are the main functions of the money market?

The money market serves several important functions, including providing a platform for short-term borrowing and lending, facilitating liquidity management for financial institutions, and enabling the efficient allocation of funds between surplus and deficit units.

How does the money market help in liquidity management?

Financial institutions use the money market to park excess funds or meet short-term funding needs. They can quickly convert their liquid assets into cash by participating in money market transactions.

What types of financial instruments are traded in the money market?

The money market trades instruments like Treasury bills, commercial papers, certificates of deposit, repurchase agreements, and short-term government securities. These instruments are low-risk and have short maturities.

What role does the money market play in monetary policy?

Central banks use the money market to implement monetary policy. They can influence interest rates by buying or selling government securities in the money market, thereby affecting the overall money supply and economic conditions.

How does the money market help corporations and governments manage their finances?

Corporations and governments use the money market to raise short-term funds quickly and at lower interest rates compared to longer-term borrowing. This helps them meet immediate financial obligations and smooth out cash flow fluctuations.

About the Author
author-image
Chanchal Aggarwal
Senior Executive Content

Chanchal is a creative and enthusiastic content creator who enjoys writing research-driven, audience-specific and engaging content. Her curiosity for learning and exploring makes her a suitable writer for a variety ... Read Full Bio