Elements in Financial Services and Markets - Case Study Example

Elements in Financial Services and Markets Table of Contents Elements in Financial Services and Markets 1 Table of Contents 1 Financial Markets 1 Financial Markets and the Officially Determined Interest Rates 2 Financial Markets and Government Spending Decisions 5 Collecting tax revenues 5 Open Market Operations 6 Seigniorage 6 Conclusion 7 References 8 Financial Markets Financial markets play a regulatory role in determining the present as well as the future conditions that might prevail in an economy. However, they continue to be the most vulnerable of all the major markets comprising a nation because of the high external influence they are often subjected to. But, there are many instances as well, when the market is affected by internal conditions as well. Some such factors are – the officially determined domestic interest rates, the amount of aggregate savings in the economy, the budgetary conditions of the domestic government and some significant international factors which play a vital role in the inflow of cash into the domestic arena. This paper tries to explore the aspects of the financial market of a nation affected due to changes in the official interest rate and the government’s budgetary position. In general, the participants in the financial market of any economy mainly consist of the banking sector including the central bank as well as the commercial banks, non-banking financial sector, stock market and even individuals (Mel’nikov, 1999). In fact, it is the individual activities in both domestic and international spheres, which when aggregated play a major role in driving the operations of the financial markets. The argument in support of the above fact is that, the banks as well as financial institutions deal with private money of individuals who often respond to the changes in financial markets through mobilising their funds which might result to a further ruckus in the same. This eventually might land up the economy into a vicious circle. However, the government too cannot be excluded as a possible element responding to changes in the financial markets. Though the proportions vary by a large extent, but mobilisation of both public and private money are responsible for creating differences in the financial market scenario of a nation. Financial Markets and the Officially Determined Interest Rates Domestic interest rates play a vital role in determining the fate of the financial situation of any nation. In fact, a rise in the domestic rate of interest can influence each and every segment comprising the financial market of an economy. However, as mentioned above, the factor which acts as a pivot in this aspect is the rational individual, who predicts the future value of his assets and mobilises his finances accordingly, thus, directing the movements of the financial market in ways discussed below. In the present study, the case of a rise in the officially determined rate of interest is being taken up. However, the fall in the rate of interest, which is exactly opposite to a rise in the same, can easily be implied through a contrast of the situation, consequences and the preventive measures being discussed below. When officially determined domestic rate of interest rises, people are generally found to be allocating their money among various investment projects. The higher the rate of interest is, more will be the opportunity cost of investment and thus, lower will be the relative returns from investment. But, people often are sceptical about the future movements of interest rates and thus will withdraw some of the money invested in short-term projects to those that yield long-term results. But some of this money also lands into banks as deposits. Moreover, people often start comparing the benefits of present consumption to that of future consumption, which again is implied by present savings. Thus, the comparative advantages of future consumption often are mirrored in the form of higher savings by domestic nationals. Again, in the international sphere where investment is often guided by interest rate parity, investors are found to be arbitraging their financial assets between regions that have differential rates of return on assets, so that the gap in the interest rates become the profits which they can ultimately pocket. Thus, if the domestic rate of interest in country A is found to be greater than that in country B, then many investors residing in the latter nation might want to invest their money in country A, expecting a gain. This eventually leads to a bulk of cash inflow within the nation (Madura, 2006). Now, given the sort of behaviour that people are expected to exhibit in an environment characterised by a high domestic rate of interest, different segments of the financial market are found to behave in the following manners – Banks – Investors all over the concerned economy will reallocate their portfolio and hence the money supposed to be used for investment purposes. A majority of the money to be utilised in investment projects will now be allotted as deposits to be kept with the banks, since bank deposits usually have a comparatively lower risk associated with them. Moreover, there will be a high inflow of foreign exchange as well, since many foreign arbitragers interested in gaining from the positive difference in the interest rate between the two nations take advantage of the situation. Thus the domestic banks will have a huge reserve of cash with them, although the residents will want to keep very little money in their hands. In fear of recession, the central bank of the concerned nation might propose a cut in the lending rates so that there will be a sudden availability in the amount of loanable funds within the country. Gradually, the liquidity in the nation will rise and a ground for inflationary developments will be created. In fact, this is what the whole world witnessed in the middle of the present decade, when almost all nations around the world was submerged under the sub prime crisis, initiated by the Federal Reserve’s decision to hike and then decline the domestic rate of interest (Rogers, 1989). Non-bank Financial Institutions – Non-bank financial institutions include insurance companies, etc. which are not held responsible for holding money deposits or reserves, so that these institutions do not have a direct advantage from a higher inflow of money into the nation. However, if the central bank of a nation responds to a high rate of interest with a policy of increased liquidity, people will have more money in the form of loanable funds in their hands, thus leading to a rise in the demands of the people. These demands might even take the form of increased demand for insurance schemes, so that people may ensure a secure future. Hence, the higher the liquidity in the economy, higher will be the flow of money in the hands of these institutions. However, the condition which must be satisfied is that the central bank of the nation must respond with a fall in the rate of interest on loanable funds. Stock Market – Investors respond to a hike in the rate of interest by withdrawing their money from the share market, which is reflected through a vigorous trade of stakes in lieu of money. Since the opportunity cost of investing in shares are probably going to rise, there will be a sudden downfall in the demand of shares and a rise in the amount of money deposited in banks. However, a fall in the demand of the former leads to a fall in the market value of shares and thus a fall in the value of the share market index, which is but a clear sign of a falling market conditions. On one hand, a falling market condition might discourage investors from investing in new projects so that the quantity of present investments will fall, subsequently leading the limited companies to depend less on share-holders’ money and more on debts for financing. On the other hand, people will prefer to save more than consume and thus banks will have an abundant supply of loanable funds, so that there will be ample resources to provide funds meant for future investments. Hence, a rise in the rate of interest although leads to a dwindling condition of the financial market of any nation, it results to a rise in the amount of future investments in the nation as well. Again, the feeble and recession prone financial condition of the concerned nation following a rise in the rate of interest could be taken care of in case the respective central government responds through a corresponding fall in the rate of interest on loanable funds. Financial Markets and Government Spending Decisions Apart from officially determined domestic interest rate levels, another important factor affecting the developments in the financial market of a nation is the spending decision made by the government or the government’s budgetary conditions. This is how the movements of public money can affect the financial conditions of an economy. Generally government spending is financed in three ways – collecting tax and enhancing the revenue collected from it, open market operations where the government of any nation is found to buy and sell government (more specifically, treasury) bonds and thirdly through seigniorage where domestic currency notes are printed in order to bring the government in a position to make its purchases (Agell, Persson & Friedman, 1992). All these processes are reversed in case the government wants to cut back its expenses. The money supply in the economy, however, will be largely affected with variations in the spending decisions of the government of a nation. In this case too, like in the previous section, the consequences of only one possible situation, viz., the case when the government decides to raise its expenditures, will be undertaken and the opposite case would be implied as a corollary. Collecting tax revenues When the government spending are financed via a rise in the amount of tax revenues, it implies a fall in the disposable income of the people and hence a fall in their power to either afford to buy more stocks or to maintain a high balance compared to the case when the bank allowed a high rate of interest, so that the latter do not have the funds necessary to advance as loans to the people demanding it at reasonable prices. Hence, the rate of interest on loanable funds will be high and their supply will be low as well. Open Market Operations Open market operations imply the buying and selling of government bonds in the market, so as to adjust the amount of money the government has in store for its own spending. In case that the government of any nation decides to raise its expenses, it needs to sell off some of its bonds in the open market so that the people who possess them earn a specified amount of interest over them till the period they decide to hold them and on the other hand, the government is better off in terms of availability of funds in its hands. However, when private individuals decide to buy government bonds, although they are earning a certain amount of interest over time on the bonds, they are also playing an active role in reducing the liquidity in the economy, i.e., create a monetary crunch in the nation. In this case however, unlike that in the case of the above, the disposable income of the common man does not fall, but his power to make purchases do because of the fall in the availability of liquid money in his hands. Seigniorage The term implies the printing of new currency notes so as to meet the obligations and the necessities of the domestic government. Quite contrary to the already two other modes of collecting money, this process do not affect the disposable incomes or the purchasing power of the national people. In this case, the government spends in areas that it wishes to invest its money into and pays in terms of the newly printed money. In most of the cases it is found that the money goes out of the nation, but in some instances where the money is found to be circulated back into the country, the country lies under a heavy threat of excessive supply of money within the economy and hence an inflation. When the money hovers around within the nation and ends up in the hands of the domestic nationals, it results to a rise in the money supply within the economy and thus a rise in the purchasing power of the people. However, more the quantity of money that the people have at hand, more will they start demanding and thus given that the nation acts at its full-employment level, there will be a high probability that the economy is submerged under the grasps of inflation (Goldstein, 2002). Thus the main difference between seigniorage and the other two ways discussed above is that, in the latter, the quantity of money being circulated within the nation remains the same but in the former, it might not be the case. Again, in case of either higher tax revenue collection or open market operations, the purchasing power of people are found to fall, so that the aggregate demand falls and the nation is expected to slip down into recession. But, in case the government decides to finance its expenses through seigniorage, the quantity of money people have at hand rises and so does the aggregate demand in the economy. Since there is no attraction to deposit the money in banks, unless there they are providing a high rate of interest, people would prefer to invest their money in the secondary stock market. This act again leads to a rise in the value of the market index. However, a rise in stock prices in excess of their actual value defined by the company fundamentals, leads to the formation of a bubble which might burst all of a sudden, leaving the economy in recession. Hence, in all of the three situations discussed above, the preventive measures that could be taken are different. In cases of either higher tax collection or open market operations, the situation of liquidity crunch can be tackled through a lowering in the rate of interest on loanable funds and even on bank deposits so that people once again find it attractive to hold liquid money in their hands. However, in case there is a rise in money supply due to seigniorage, the measures undertaken should be exactly the opposite of what it was in the previous case. Conclusion Financial markets as discussed in the introduction to the paper are the most vulnerable of all market comprising an economy. Any changes in the fiscal or monetary policies of the national government can lead to havoc changes in the same. The present paper discussed the consequences of one fiscal policy (change in government spending) and one monetary policy (change in the rate of interest) on the financial market of an economy. The aftermath effect of any policy change depends largely upon the way in which a certain step has been taken. Again, the path of implementation also decides the fate of each segment or participant of the financial market in any economy. Due to the high susceptibility of the financial market to policy decisions and the way of their implementation, the exact and appropriate path must be decided upon before taking further steps in this aspect. The consequences of even a slight mistake might lead the nation to sink beneath the tides of inflation and even recession. Thus, unless the policy acts as a controlling factor, there must be some other ways invented as well so as to take care of any aftermath of the strategy being undertaken. References Agell, J., Persson, M & Friedman, B. M. (1992) Does debt management matter? FIEF Studies in labour market and economic policy. London: OUP. Goldstein, M. (2002) Managed floating plus. Massachusetts: Institute for International Economics. Madura, J. (2006) International Financial Management (8th Edition). London: Thomson Learning. Mel’nikov, A.V. (1999) Financial markets: Stochastic analysis and the pricing of derivative securities. USA: The American Mathematical Society. Rogers, C. (1989) Money, interest and capital: A study in the foundations of monetary theory. Melbourne: Cambridge University Press. Read More