How Money Market Impacts Other Markets?

In the previous articles, we have learned that the money market is a very important market in our financial system. However, it is also important to note that the money market can have an impact on almost all other financial markets.

Central banks all over the world try to control the monetary policy of their country by controlling the money markets. This is because they view the money markets as being central to the overall economy. Money markets form the base of the financial market system and have linkages to various other markets. This is what makes them essential to the well-being of any financial system.

This article explains how money markets are integrated with other financial markets.

Interbank Markets Impact Credit Creation

The interbank market is the biggest and the most important component of the money market. The interbank market is essential for the smooth functioning of the banking system. Banks with excess reserves transfer money to banks that lack in reserves.

It is important to note that banks are able to offer loans and create credit only because they are confident that at the end of the day they will be able to borrow from the interbank market and balance their books.

If the interbank market is taken out of the equation, banks will face a lot of issues. This is because before making each and every loan, banks will have to ensure that they have sufficient reserves on hand. This will slow down the process of credit creation.

Now, credit creation is important to the functioning of the overall economy. The loans which are made by banks are given to individuals as well as to corporations. Individuals use these loans for consumption purposes whereas businesses use these loans for productive purposes.

In both of these cases, the economic activity ends up increasing. Heightened economic activity is the basis on which stock markets rise. Hence, in a way, the stock markets are linked with the interbank lending market. This means that if there is a significant problem in the interbank market, then the stock markets are also likely to be impacted by it.

Money Markets Affect the Issue of Government Bonds

Money markets also form the very basis of the bond market. The sale and purchase of government securities is the most important transaction in any bond market. These are the transactions using which the central bank exerts control over the short-term interest rate. However, money markets enable the purchase of these securities. This is because governments sell these securities to dealers. These dealers do not have the liquidity required to purchase these securities.

Instead, they use the money market to access the cash required to purchase these securities. They quickly purchase these securities, sell them and return the money to the larger market. However, if there is some duress in the money market, these dealers will not be able to access the cash required. This will affect the demand for government securities which in turn will impact the interest rate offered on those securities. It is a known fact that the interest rate paid by the government serves as the benchmark for the interest rate which needs to be paid by everyone else.

Hence, in a way, turmoil in the money market could quickly escalate to the bond market. Bonds issued by private entities as well as by the government are likely to be impacted by this turmoil.

Money Market Also Have An Impact On The Foreign Exchange Market

We have already seen from the points above, that the money market has the potential to impact and even alter the short-term interest rate in the market. Now, it is important to note that the interest rate is an important determinant of demand and supply in the foreign exchange market.

If the interest rate offered by a currency goes up, more investors want to invest in that currency. As a result, the demand for that currency also rises significantly. Hence, the foreign exchange market is altered by the changes in the money market. This is the reason that most investors in the foreign exchange market also keep an eye on the events happening in the money market.

Effect of Money Market on Alternate Assets

The money market has a direct impact on the stocks, bonds, and foreign exchange market as demonstrated above. However, it needs to be understood that the money market also has a huge impact on alternate assets such as gold and real estate.

The money market plays an important role in signaling the rise of inflation. When investors see that the short-term interest rates are very low and are not likely to increase in the near future, they tend to buy gold. This is because gold provides a hedge against rising inflation.

Similarly, when the interest rates are low, real estate prices tend to rise. This is because the affordability of homes increases and more people buy homes. Once again, since the money market is a leading indicator of rising as well as falling interest rates, it can be said to be intertwined with the real estate market as well.

To sum it up, it is somewhat astounding that even though retail investor has not heard much about money markets, this market has such a huge impact on their lives.