The money market is an organized exchange market where participants can lend and borrow short-term, high-quality debt securities with average maturities of one year or less. The market enables governments, banks, and other large institutions to sell short-term securities to fund their short-term cash flow needs. It also allows individual investors to invest small amounts of money in a low-risk market. Some of the instruments traded in this market include treasury bills, certificates of deposit, commercial paper, federal funds, bills of exchange, and short-term mortgage-backed securities and asset-backed securities.
Large corporations with short-term cash flow needs can borrow from the market directly through their dealer while small companies with excess cash can borrow through money market mutual funds. Individual investors who want to profit from the money market can invest through their money market bank account or a money market mutual fund. A money market mutual fund is a professionally managed fund that buys money market securities on behalf of individual investors.
Functions of the Money Market
The money market contributes to the economic stability and development of a country by providing short-term liquidity to governments, commercial banks, and other large organizations. Investors with excess money that they do not need can invest it in the money market and earn interest.
The main functions of the money market:
1 Financing Trade
The money market provides financing to local and international traders who are in urgent need of short-term funds. It provides a facility to discount bills of exchange, and this provides immediate financing to pay for goods and services. International traders benefit from the acceptance houses and discount markets. The money market also makes funds available for other units of the economy such as agriculture and small-scale industries.
2 Central Bank Policies
The central bank is responsible for guiding the monetary policy of a country and taking measures to ensure a healthy financial system. Through the money market, the central bank can perform its policy-making function efficiently. For example, the short-term interest rates in the money market represent the prevailing conditions in the banking industry and can guide the central bank in developing an appropriate interest rate policy. Also, the integrated money markets help the central bank to influence the sub-markets and implement its monetary policy objectives.
3 Growth of Industries
The money market provides an easy avenue where businesses can obtain short-term loans to finance their working capital needs. Due to the large volume of transactions, businesses may experience cash shortages related to buying raw materials, paying employees, or meeting other short-term expenses. Through commercial paper and finance bills, they can easily borrow money on a short-term basis. Although the money market does not provide long-term loans, it influences the capital market and can also help businesses obtain long-term financing. The capital market benchmarks its interest rates based on the prevailing interest rate in the money market.
4 Commercial Banks Self-Sufficiency
The money market provides commercial banks with a ready market where they can invest their excess reserves and earn interest while maintaining liquidity. The short-term investments such as bills of exchange can easily be converted to cash to support customer withdrawals. Also, when faced with liquidity problems, they can borrow from the money market on a short-term basis as an alternative to borrowing from the central bank. The advantage of this is that the money market may charge lower interest rates on short-term loans than the central bank typically does.