Financial Markets and Monetary Policy

Financial Markets and Monetary Policy

Financial markets are places where such financial resources as shares, bonds, derivatives and mortgages are traded. Their purpose is to steer capital towards its most productive use.

Banks and other professional investors gather information about a wide range of investment opportunities and invest the savings entrusted to them in the most attractive projects. In practice, though, the future is hard to foresee and such schemes does not always bear fruit. Indeed, considerable sums are sunk in the unsuccessful ones. In addition, financial markets are subject to excesses as players adopt the behaviour of their peers and reinforce existing trends. Despite all its extremes and irrationalities, however, the finance sector performs an important societal function. If people had to save for years to raise the money necessary for an investment themselves, the capital stock and thus also labour productivity would be much smaller.

An increasingly important role in the financial markets is being played by central banks, which fix the base rates for the interest at which the private banks can lend each other money. Moreover, the European Central Bank (ECB) has recently started to intervene itself, buying government bonds in large quantities. The ECB has also taken on the task of supervising the banks and keeping the financial markets stable.

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Keeping the value of money stable guarantees sustainable and stable economic development. Phases of excessive devaluation undermine confidence in purchasing power and cause an unjustified redistribution between debtors and creditors.

The European Central Bank (ECB) is committed to price stability. Its aim is to keep the inflation rate just under 2% in the medium-term. Overall the ECB has performed this task well, helping to ensure that the infant euro got off to a successful start. Primarily by setting the base rate, the Central Bank steers interest rates on the interbank market, the market on which the banks conduct their financial transactions with each other and with the ECB.

From the basic money supply thus made available to them, the banks use loans and purchases of securities to provide the money needed by individuals and companies in daily commerce. The challenge for the Central Bank is to choose the correct interest level to prevent too much money circulating in the economy, leading to inflation.

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Worldwide financial transactions have recently increased dramatically. The daily volume of currency dealing alone equals the annual economic output of a medium-sized industrialised nation. The financial markets direct money where it can be most productively used.

Whenever a funding bottleneck develops somewhere in the world interest rates soar and attract capital. Developing and threshold countries offer particularly high returns as capital which can be used to fund projects and create jobs is scarcer there than in industrialised countries. The free flow of capital increases the prosperity even of those without assets. The money borrowed finances new plants and machinery which make labour more productive and raise wages. To attract capital, governments must create favourable investment conditions by improving infrastructure and promoting education.

For financial markets to be able to function there must be clear rules. Repeated financial crises have shown that markets can produce disastrous developments when the underlying structures are faulty. To prevent a damaging race between countries to offer ever laxer regulation and to avoid financial crises spilling across borders, the world’s nations must reach agreement on minimum standards and a global financial institution to monitor compliance.

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